Solving the climate finance equation for developing countries

As climate change indicators continue to break records and global temperatures and extreme weather events advance, the urgency to act to ensure a sustainable future is mounting.¹State of the global climate in 2022, World Meteorological Organization, April 2023; The net-zero transition: What it would cost, what it could bring, McKinsey Global Institute, January 2022. Achieving the goals of the Paris Agreement will require fundamental changes in energy and land-use systems worldwide, and developing countries are a key part of this transformation.²For the climate finance analyses in this report, “developing countries” refer to low- and middle-income countries but exclude China.

Poised as they are for significant economic and population expansion, without support for decarbonization and green growth developing countries will likely increase their share of emissions over the coming decades. However, the climate conversation around these countries can often be focused on adaptation and resilience to withstand changes from climate change, rather than the decarbonization efforts that could mitigate its worst effects and position these economies for green growth. This could undermine global progress toward net zero and, ultimately, erode economic prosperity in developing nations.

In this article, we explore how economic growth, inclusion, and climate action are intimately connected and estimate the climate financing gap that needs to be bridged to ensure adequate financing of climate imperatives in Africa, Asia, and Latin America. Nine levers are highlighted that could help attract the private and public funding required to unlock investments to build a safer and more prosperous future, not just in these regions but for the world more broadly.

Developing countries have a critical role to play in the global transition to net zero

Over the next decade, the economies and populations in developing countries are projected to be among the fastest growing in the world. Between now and 2050, half of additions to the global population will likely be in Africa and about 30 percent in Asia.³“African century,” IMF, September 2023; “World population prospects 2022,” United Nations; “Data portal—population division,” United Nations, October 10, 2023. Furthermore, the International Monetary Fund (IMF) estimates that, compared to 2021, developing countries’ GDP could increase by 40 percent to more than $60 trillion by 2028, a per-capita increase of over 30 percent.⁴“World economic outlook database,” IMF, April 2023.

However, climate change could limit or even derail this progress. Average temperatures have risen by about 1.2°C since the pre-industrial era and, globally, temperature and precipitation extremes are already 4.8 and 1.3 times more likely to occur, respectively.⁵Sixth assessment report, WG1, figure SPM.6, Intergovernmental panel on Climate Change (IPCC), March 20, 2023. Developing countries are the most vulnerable to these impacts (Exhibit 1). In August 2022, for example, Pakistan experienced severe flooding that covered a third of the country, resulting in around 15,000 casualties and displacing 8 million people.⁶Ijaz Nabi, “Responding to Pakistan floods,” Brookings, February 10, 2023.

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Africa is considered the most climate-vulnerable region in the world owing to a high dependence on ecosystem goods (such as clean air, water, and fertile soil) for livelihoods, underdeveloped agricultural systems, limited infrastructure, a lack of social safety nets, and lower adaptive capacity (linked to weaker economies, institutions, and governance structures).⁷“Responding to climate change,” United Nations Environment Programme, October 10, 2023. In 2022, Niger and Nigeria faced one of the deadliest floods in recent history, damaging 300,000 homes, inundating half-a-million hectares of land, and resulting in more than 800 fatalities.⁸“Climate change exacerbated heavy rainfall leading to large-scale flooding in highly vulnerable communities in West Africa,” World Weather Attribution, November 2022. In the Horn of Africa in the east of the continent, an acute drought has affected over 20 million people and led to the loss of over 2 million livestock in Kenya alone.⁹“The Horn of Africa is facing an unprecedented drought. What is the world doing to help solve it?,” World Economic Forum, July 21, 2022; Jarso Mokku, “Climate change destroys the livelihoods of Kenyan pastoralists,” UN Africa Renewal, January 4, 2023. Projections indicate further increases in such climate-related incidents, likely leading to a broad range of social and economic impacts.¹⁰Holli Riebeek, “Climate change,” NASA Earth Observatory, June 3, 2010.

As a result of these risks, the climate conversation around developing countries, especially in Africa, can often be focused on adaptation and resilience rather than decarbonization. However, taking decisive decarbonization action in these countries would be needed to support the world’s transition to net zero and thus be vital to ensure that they avert the worst climate change impacts.

Developing countries already account for a sizable share of emissions and, given future population and GDP growth projections, this is set to rise. While the Organisation for Economic Co-operation and Development (OECD) countries have made some progress, reducing their emissions by 8 percent between 2010 and 2019, the rest of the world saw a 22 percent increase in emissions during this time.¹¹“Greenhouse gas emissions,” OECD, October 10, 2023; “Greenhouse gas emissions by country,” Our World in Data, October 10, 2023. At around 10 percent of the global total (when land-use emissions and all greenhouse gases are considered), Africa already accounts for more greenhouse gas (GHG) emissions than Europe; however, per capita emissions are still higher in Europe.¹²“Green Africa: A growth and resilience agenda for the continent,” McKinsey, October 28, 2021; “Greenhouse gas emissions by country,” Our World in Data, July 30, 2023. Indeed, as recent modeling work has shown, in a scenario where industrialized countries achieve a 1.5°C-consistent emissions trajectory but Africa, India, and Southeast Asia follow a “current policies” trajectory, global GHG emissions would remain substantial by 2050, leading to an increase in global average temperatures by 2100 of 2 to 2.3°C. This would miss the Paris Agreement goals and lead to substantially higher risks of triggering self-reinforcing warming feedback loops in the Earth’s system.¹³Investor roadmap for an emerging market green transition, a joint report by LeapFrog Investments, Temasek, and CGAP, November 2023.

In short, it is likely only possible to limit warming and achieve the Paris Agreement goals if developing countries achieve a green growth, low-carbon development pathway. Moreover, such a pathway also holds significant potential to deliver new economic opportunities to developing countries.

Setting a course for green growth

The stage is set for significant green growth in developing countries. Climate investments by industrialized countries have dramatically reduced the cost of many clean technologies—a trend that is likely to continue—making renewable energy the lowest-cost power source in large parts of the world.¹⁴“Renewable power remains cost-competitive amid fossil fuel crisis,” International Renewable Energy Agency (IRENA), July 13, 2022. Many other clean technologies are also rapidly approaching tipping points where their costs are becoming lower than those of high-emission incumbent options. Choosing low-carbon technologies will soon be the economically rational choice across large parts of the global economy, further lowering costs and increasing productivity. In many cases, clean technologies also have significant co-benefits such as cutting air pollution, improving sanitation, increasing energy access, and more.

Developing countries have a significant opportunity to leverage these technologies to build low-carbon development pathways. McKinsey research has previously highlighted ten high-potential green growth opportunities for Africa centered around four key pillars—energy access and affordability, inclusive green growth, health and quality of life, and green exports—that could create jobs and bring new export revenue to the continent (Exhibit 2).

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For example, thanks to its abundant renewable resources, Namibia is advantageously positioned to produce and export green hydrogen, a vital resource for decarbonization, especially in hard-to-abate sectors.¹⁵Hydrogen for net-zero: A critical cost-competitive energy vector, a joint report by the Hydrogen Council and McKinsey & Company, November 2021.

Global hydrogen demand is expected to increase from 140 megatons per annum (Mtpa) of hydrogen equivalent in 2030 to 660 Mtpa in 2050, owing to its versatility and unique ability to connect power, gas, chemicals, and fuel markets.¹⁶“Building towards Namibia’s green hydrogen future,” GH2 Namibia, November 2022. Namibia aspires to create an at-scale green hydrogen industry with a production target of 10 to 12 Mtpa hydrogen equivalent by 2050 for export to Asia and Europe. Capturing this opportunity could boost GDP by up to $6 billion by 2040—an increase of 50 percent on today’s GDP—and create up to 600,000 jobs by 2040.¹⁷“Building towards Namibia’s green hydrogen future,” GH2 Namibia, November 2022.

Indeed, as the Namibian example shows, the role of developing countries in the world’s energy transition can extend well beyond decarbonizing their economies. For instance, many countries in Africa, Asia, and Latin America are rich in the mineral resources essential for clean energy technologies and renewable resources that could enable the production of sustainable and clean energy, reducing environmental impact, and fostering long-term energy security (see sidebar “The role of developing countries in the net-zero transition extends beyond their domestic emissions”).

Bridging the climate finance gap in developing countries

Delivering on the potential for decarbonization and green growth in developing countries will require a significant increase in climate-focused investment. Based on capital deployed in 2019, our research indicates that about $2 trillion in additional finance is needed per annum by 2030 to meet the Paris Agreement goals and cap warming at 1.5°C above pre-industrial levels (Exhibit 3). This amount includes investments needed to transform the energy system, respond to growing climate change vulnerability, scale sustainable agriculture, and restore natural capital and biodiversity. An additional $3 trillion per annum is also required to invest in the human capital and broader infrastructure needed to meet the development goals of developing countries.¹⁸Bhattacharya et al., Financing a big investment push in emerging markets and developing economies for sustainable, resilient, and inclusive recovery and growth, LSE Policy Publication, May 23, 2022.

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To secure this funding, various domestic and international sources of climate finance would need to be explored—including new sources of concessional capital (see sidebar “Sources of climate finance”).

As of 2019, about $450 billion of climate finance was deployed annually in developing countries, roughly 20 percent of what is needed by 2030.¹⁹Bhattacharya et al., Financing a big investment push in emerging markets and developing economies for sustainable, resilient, and inclusive recovery and growth, LSE Policy Publication, May 23, 2022. Around 60 percent of this capital was directed at the energy transition, with the remaining 30 percent allocated to agriculture, food, and land use, and 10 percent to nature, adaptation, and resilience.²⁰Bhattacharya et al., Financing a big investment push in emerging markets and developing economies for sustainable, resilient, and inclusive recovery and growth, LSE Policy Publication, May 23, 2022.

Research indicates that, of the additional $2 trillion needed for climate financing in developing countries, about $830 billion (approximately 40 percent) could come from domestic resource mobilization (DRM), based on a weighted average of the percentage of domestic capital compared to external capital sources across all sectors of the economy (see sidebar “Uncertainties and additional complexities”).²¹McKinsey analysis. This amount equates to a 15 percent increase in total DRM from 2019. Of this, about 40 percent is likely to come from “business as usual” GDP growth, but the bulk would require additional capital mobilization measures from public and private sources.

The remaining 60 percent of the financing gap (about $1.1 trillion per annum) would need to be filled externally from international capital sources—both private and public, as not all climate investment needs are suitable for private capital.²²McKinsey analysis. Mitigation efforts typically have a business case that can attract private capital on a stand-alone basis, or public sector actors that are able to derisk the investments sufficiently to crowd in private capital through the use of instruments such as debt guarantees or first-loss capital investments. By contrast, adaptation is likely to require predominantly public or concessional funding. This gap could be filled partially by achieving higher leverage ratios (private sector investment mobilized for each dollar of concessional finance) on existing international concessional climate finance. However, significantly more concessional finance would also be required.

Additional domestic capital mobilization measures

In the longer term, capital mobilization from sovereign (public) sources could be accelerated by growing the tax base through accelerated economic growth—for example, by implementing green growth strategies. But in the near term, enhanced tax collection could play a key role. On average, lower- and middle-income countries collect only 15 to 20 percent of GDP in tax revenue versus more than 30 percent for upper-income countries.²³World Bank Blogs, “Increasing tax revenue in developing countries,” blog entry by Pierre Bachas, Florence Kondylis, and John Loeser, February 1, 2021.

Additionally, eliminating fossil fuel subsidies in some countries as well as decreasing debt burdens and borrowing costs could free up public funds. In 2021, African countries dedicated 14 percent of income from exports of goods and services, primary income, and workers' remittances to external debt servicing.²⁴“Africa feels the strain from elevated debt,” Economist Intelligence Unit, 2022. Automatic interest moratoriums in the event of catastrophes, sovereign debt restructuring, including measures such as debt-for-climate swaps, and reducing borrowing costs through measures to reduce country risk and increase sovereign bond liquidity through better-developed repo markets could be critical to lower the interest burden and free up the necessary capital. However, it is important to bear in mind that an increase in sovereign capital mobilization may be slowed down by headwinds caused by the impact of the COVID-19 pandemic, supply impacts from the conflict in Ukraine, rising interest rates, and debt distress.

To mobilize additional domestic capital from private sources, measures that incentivize local finance deployment would likely need to be developed. This could include deepening local financial sectors through improved regulation and oversight, risk assessment frameworks, or capability building.

Raising more international climate finance

There are two primary ways to increase the amount of international climate finance: a more effective use of existing concessional finance to mobilize more private investment and increasing the amount of concessional finance. Both would be needed to close the climate finance gap in developing countries.

Crowding in more private investors would require a more effective deployment of public capital to drive higher leverage ratios on concessional capital. Currently, leverage ratios of blended finance arrangements of development finance institutions (DFIs) and multilateral development banks (MDBs) are often less than one.²⁵Samantha Attridge and Christian Novak, “An exploration of bilateral development finance institutions’ business models,” ODI, December 2022; Nancy Leigh, “More mobilizing, less lending a pragmatic proposal for MDBs,” Center for Global Development, April 2018.

McKinsey estimates an achievable leverage ratio of about 1.6, that is, about $1.6 of private capital mobilized for every $1.0 of public or concessional finance.²⁶Throughout this report, when leverage ratios are mentioned, it refers to the amount of private sector capital catalyzed as a result of public capital deployment. Leverage ratios vary based on the type of instrument, geography, time, and source. The 1.6 leverage ratio used here represents a weighted average of a representative mix of climate finance instruments for low- and lower-middle-income countries (as defined by the World Bank)—49 percent concessional capital, 21 percent guarantees, 21 percent technical assistance, 8 percent grant, 2 percent results-based financing instruments. Using this ratio and considering a low private sector participation in adaptation-related investments, the financing gap remaining after realizing the potential for increased domestic resource mobilization could be closed with an additional $600 billion per annum of public concessional finance, including multilateral and bilateral financing, and about $500 billion per annum from private international capital.

Based on this analysis, it is clear that significant additional concessional climate finance is required. Several proposals are already being discussed to increase public concessional climate finance through MDB and DFI reforms. For example, the Bridgetown Agenda looks at how existing MDB and DFI balance sheets could mobilize more capital deployment through changes to capital adequacy requirements or the reallocation of special drawing rights.²⁷“The Bridgetown Initiative to reform the international financial architecture,” Global Policy Forum, February 22, 2023. The Blended Finance Taskforce estimates that proposed reforms to MDBs and DFIs could mobilize about $120 billion of additional concessional finance per annum, which, in turn, could crowd in approximately $190 billion in additional private finance.²⁸Better guarantees, better finance: Mobilising capital for climate through fit-for-purpose guarantees, Blended Finance Taskforce, 2023. This could close 20 to 30 percent of the climate finance gap after potential increases in domestic resource mobilization are accounted for.²⁹Better guarantees, better finance: Mobilising capital for climate through fit-for-purpose guarantees, Blended Finance Taskforce, 2023.

This leaves an estimated remaining gap of about $480 billion per annum in additional concessional (external public) finance required by 2030. This number is substantial, equivalent to more than double the total (not only climate-related) 2022 disbursements of the top five DFIs or the total official development assistance received from OECD countries in 2022.³⁰Top five by assets under management—excluding China Development Bank. Includes Asian Development Bank, European Investment Bank, Inter-American Development Bank, KfW Development Bank, and the World Bank Group. It implies more than quadrupling the currently committed $100 billion per annum North–South concessional climate finance, or tripling official development assistance to just over 1 percent of OECD countries’ 2022 gross national income, up from currently 0.36 percent.³¹An OECD update on official development assistance (ODA) shows foreign aid from official donors rose to an all-time high of $204 billion in 2022; “Official development assistance (ODS),” OECD, 2022. Moreover, this amount would only cover the estimated climate finance gap and does not account for additional development finance needs for non-climate investment into human capital, health, or infrastructure.

Nine key levers to catalyze funding for developing countries

To spur investment in developing countries, we highlight nine key levers that could be deployed across three dimensions: increasing external concessional capital, enabling more private foreign direct investment (FDI), and increasing sovereign and private domestic resource mobilization. This is by no means an exhaustive list but rather represents priority actions with the highest impact and probability of success in increasing the amount of climate finance flowing toward these regions (Exhibit 4).

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Increasing external concessional capital

Increasing external concessional capital can be achieved, first, through increasing capital deployment from existing institutions’ capitalization. The Bridgetown Agenda, for example, proposes leveraging unused IMF Special Drawing Rights as collateral to lend to climate projects in developing countries and to adjust capital adequacy requirements to mobilize more capital through existing MDB balance sheets. Second, new international concessional climate finance could be raised through new instruments like the Loss and Damage Fund agreed at COP27, as well as through new levies that have been proposed such as global climate taxes and levies.³²“COP27 reaches breakthrough agreement on new “Loss and Damage” Fund for vulnerable countries,” United Nations Climate Change, November 20, 2022. Third, additional capital could be sourced by shifting more philanthropic funding towards climate, specifically in developing countries. Philanthropy is unique as it is flexible and has fewer constraints than other sources of capital but currently it plays a minor role. A 2018 Harvard Kennedy School report found that only 1 to 2 percent of the $875 billion philanthropic capital deployed was directed to climate change, though this share has likely risen since.³³The world's philanthropic organizations focus primarily on education, human services and social welfare, health, and arts and culture. Education is a universal priority as it is viewed as a key to individual opportunity and achievement and an engine of national economic prosperity. Priority areas today align with a) national government priorities and b) Sustainable Development Goals (for example, in 2018, over half of the 544 foundations explicitly aligned their activities with the SDGs); Global philanthropy report, Harvard Kennedy School, 2018. In previous research, McKinsey has laid out the potential for philanthropy to drive catalytic investments, take risks, and innovate in climate finance.³⁴“It’s time for philanthropy to step up the fight against climate change,” McKinsey, October 20, 2021.

Enabling more private foreign direct investment

Delivering on priority actions to drive private FDI

Mobilizing private capital is the crux of the climate finance debate because, in addition to private investors’ ambitions, it requires efforts from domestic stakeholders and international institutions to create the right investment conditions. Here, we examine how stakeholders can deliver on the three priority actions identified to enable more private FDI.

Expanding the use of finance instruments with higher leverage ratios to catalyze private capital

By employing innovative finance mechanisms such as blended financing and credit enhancement tools, stakeholders could amplify the impact of private capital more effectively than traditional concessional debt and encourage substantial additional investments. According to the OECD, blended concessional finance can cover the political, regulatory, and new technology risks—among others—that the private sector cannot, and provide risk mitigation in areas where no or limited market solutions are available for derisking through, for example, insurance or guarantees.¹DAC blended finance principle 4: Focus on effective partnering for blended finance guidance note and detailed background guidance, OECD, 2020.

Not all blended finance instruments are created equal. Guarantees and equity, on average, have the highest leverage ratios, while performance-based instruments have the lowest (exhibit). However, in 2020, guarantees and equity accounted for a much lower share of climate finance in Africa compared to other regions. For example, equity only accounted for about 10 percent of climate investment flows in Africa in 2022, compared with more than 30 percent globally.²Landscape of climate finance in Africa, Climate Policy Initiative, September 2022; Barbara Buchner et al., Global Landscape of Climate Finance 2021, Climate Policy Initiative, December 2021.

As things stand, DFIs and MDBs account for most of the financing in developing countries, especially in Africa, where they contributed 57 percent of financing in 2019 to 2020.³Landscape of Climate Finance in Africa, September 2022. However, DFIs' approach to mobilization has been slow to evolve, continuing to rely on traditional approaches and making limited use of structuring techniques and instruments with high mobilization potential. As a result, the instruments used have poor leverage ratios—0.3 for MDBs and less than 1.0 for DFIs.⁴Better guarantees, better finance: Mobilising capital for climate through fit-for-purpose guarantees, Blended Finance Taskforce, 2023.

Scaling private capital through blended finance hinges on increasing the flow of potential deals and achieving the required risk or return profiles for private investment in those deals. This would require coordinated action across institutions, investment approaches, and stakeholders.

Three approaches could accelerate this process. First, including climate mobilization mandates and targets for bilateral, MDB, or DFI capital is crucial, accompanied by strong organizational incentives and the development of supporting capabilities alongside suitable safeguards. Second, stakeholders could scale up and accelerate access to instruments already available through existing institutions. This could be achieved by streamlining application and co-investment processes, boosting project preparation and pipeline development, and supporting collaboration within and across public actors and combinations of blending instruments to manage risks holistically. Finally, stakeholders could grow the impact of guarantee approaches by optimizing products for greater efficiency, expanding the use of proven approaches across more providers and more challenging investment contexts, and developing new global green guarantee platforms, such as a dedicated currency risk facility.

Domestic efforts to catalyze international private capital

While increasing the amount and effectiveness of capital is critical for developing countries, it is only half the equation. Equally important is creating incentives and market conditions that will attract investors. Many developing countries are linked to significant country risk premiums, which drives up the cost of capital.⁵Finance for climate action: Scaling up investment for climate and development, Independent High-Level Expert Group on Climate Finance, London School of Economics, November 2022. For example, a consumer price index analysis for solar projects showed that, while investors in developed nations expected returns of 7 percent (Germany) and 9 percent (United States), return expectations for the same level of project risk were much higher in developing nations, with 26 percent, 38 percent, and 52 percent returns expected in Nigeria, Zambia, and Argentina, respectively.

While frequently attributed to investor bias and a lack of understanding creating a significant gap between perceived and real country risk, recent research indicates that this difference in risk premiums could, in fact, largely be caused by objectively higher risks and factors such as lower liquidity.⁶“African governments say credit-rating agencies are biased against them,” Economist, May 25, 2023; “Sub-Saharan Africa’s risk perception premium: In the search of missing factors,” IMF, June 23, 2023. International investors also face market-driven challenges, such as foreign exchange risk, but governments could directly address many of these challenges through reforms. This analysis highlights seven common challenges associated with climate finance that may need to be overcome, depending on each country’s unique economic and local context:

1. Limited public-private partnership governance: Limited legal frameworks for governing PPPs can increase the likelihood of interference, corruption, instability, and unreliable risk-sharing mechanisms. Potential interventions to combat this include deploying a standardized PPP framework and approach for climate engagements.
2. Inefficient trade environments: The market for some renewable energy products is still relatively small, a situation that could be exacerbated by inefficient trade environments that diminish the bankability of climate projects. Potential interventions that may be considered include the introduction of carbon border adjustment mechanisms (CBAMs), which place a tax on high-emission trade (for example, cement produced without deploying carbon capture and storage techniques or other decarbonization measures) and the removal of duty on low-emission products such as green minerals and manufactured goods or zero-emission vehicles. Further, standardizing processes could help simplify them and reduce the time and cost of trading.
3. Complex administrative procedures: Complicated administrative procedures can hinder the rapid deployment of available capital. To combat this, governments could consider simplifying documentation requirements and permit procedures by implementing transparent systems—for instance, by establishing a central entity to approve renewable energy projects, reducing the time and cost of business activities.
4. Restrictive capital controls: Capital controls restricting monetary and profit flows out of the country may deter foreign investors as they limit the ease with which investors can repatriate profits or move capital freely. Potential interventions to overcome this challenge could include the introduction of repatriation benefits for companies and new approaches that guarantee to limit capital controls to a fixed percentage of the economy or for a fixed period.
5. Unclear asset-dispute processes: Since climate projects frequently rely on the availability of land, investors may face land-use disputes, with unclear processes as to how to resolve these. Stakeholders could take steps to alleviate this by allocating approved land for climate projects, enabled through an inclusive, centrally managed, digital land registry, and by easing access to risk insurance. Ensuring a central body to oversee climate investment-related issues and resolution could be another potential measure.
6. Prohibited international arbitration: Some developing countries have unfamiliar judiciary systems, which may necessitate international arbitration for external investors in case of conflict. However, not all countries allow this, increasing investor uncertainty. A potential intervention could be the enforcement of country permissions for international arbitration on select matters through international treaties.
7. An environment that disincentivizes climate investments: A supportive environment can be critical in encouraging climate investment. However, existing policies (including subsidies and tax benefits) that favor high emissions are often historically embedded, while fiscal incentives and subsidies for low-emission and decarbonization projects may be limited. As seen in other countries, lowering interest rates could be considered for climate-related projects, thereby improving climate projects’ margins and bankability.⁷“Investing in climate, investing in growth: A synthesis,” OECD, May 23, 2017. Further, implementing tax incentives and other benefits for talent and capability building, renewable energy investments, energy efficiency projects, and other climate-related activities could help to attract private capital. Relevant stakeholders could also implement the gradual removal of incentives for high-emission investments and acquisition of high-emission assets, ultimately decommissioning them.

Scaling carbon markets

In recent years, voluntary carbon markets (VCMs) have emerged as a powerful mechanism to stimulate private sector capital to fund decarbonization projects in developing countries Globally, VCMs grew at about 20 percent per annum from 2016 to reach a value of roughly $2 billion in 2021.⁸Refinitiv, May 2023; “A guide to compliance carbon credit markets,” Carbon Credits, November 2023;&“VCM reaches towards $2 billion in 2021: New market analysis published from ecosystem marketplace,” Ecosystem Marketplace August 3, 2022, via McKinsey’s VCM Primer. However, countries in emerging markets frequently do not fully realize the potential of VCMs as a tool to raise climate finance and meet climate targets. For instance, Africa’s carbon credit volumes, with only 25 MtCO₂e retired in 2022, fall appreciably short of the region’s technical potential, estimated to be approximately 2,400 MtCO₂e by 2030.⁹ACMI roadmap report: Harnessing carbon markets for Africa, Africa Carbon Markets Initiative (ACMI), November 2022. The retirement value of Africa’s carbon credits in 2021 ($123 million) was just 2 percent of the continent’s potential 2030 market size if barriers are addressed.¹⁰Based on annual retirements of about 300 MtCO₂e per annum by 2030 and up to 1.5–2.5 GtCO₂e by 2050; ACMI roadmap report, 2022.

In its 2022 Roadmap Report, the Africa Carbon Markets Initiative (ACMI) identified four actions across the carbon market value chain that could help scale VCMs in Africa and other developing countries:¹¹ACMI roadmap report, 2022.

• Supplying carbon credits: The supply of carbon credits requires that project developers be scaled, for instance, through setting up an accelerator that supports high-potential nascent projects and reinforces targeted, on-the-ground technical assistance as well as the development of national enabling ecosystems, including developing fiscal policies that facilitate carbon credit applications. Validation capacity for CO₂ emissions reductions or removals needs also to be increased as it is currently a key bottleneck that is holding back developing countries’ carbon markets.
• Supporting a more integrated carbon market though intermediation: Better integration by coordinating with carbon credit exchanges and committing to common standards could help enhance carbon markets in developing countries. Additionally, introducing financial mechanisms tailored to the emerging market context could help mitigate risks and lower costs. This could involve encouraging financial institutions to value carbon revenue like other revenue streams and adjust risk frameworks to enable lending against carbon revenue, thereby promoting investment in carbon credit projects.
• Driving demand: Driving demand to increase market size could be encouraged by convening buyers through advanced market commitments, building a supply pool (for example, by launching annual requests for proposals to solicit proposals from African project developers), and facilitating transactions through an auction mechanism.
• Adopting a cross-cutting approach: Between 2016 and 2022, 95 percent of carbon credits issued in Africa were in agriculture, forestry and land use, and household devices and energy.¹²ACMI roadmap report, 2022. Stakeholders could investigate piloting new cross-cutting project types and methodologies focused on displacing fossil fuels via distributed renewable energy, coal decommissioning, and savannah grasslands’ fire management projects. Additionally, diversified financing models for nature-based assets could help scale VCMs. These include models that incorporate ecosystem value-based instruments like sustainable-use fees, payments for ecosystem services, and insurance premium discounts. Compensation-based instruments such as ecotaxes, extractive fees, royalties, and permits could be explored to scale VCMs. Throughout the process, close coordination with global standard-setting organizations such as the Integrity Council for the Voluntary Carbon Market (ICVCM), the Voluntary Carbon Markets Integrity Initiative (VCMI), and the Science Based Targets Initiative (SBTi) would be beneficial.

To enable more private foreign direct investment (FDI), countries could first expand the deployment of finance instruments with higher leverage ratios in the climate space, for instance, insurance, guarantees, blended finance structures, or currency hedging. Second, they could implement actions that improve country risk and the investment environment, for example, through structural domestic reform to improve public-private partnership (PPP) law, removing red tape, tackling corruption, and lifting capital controls. A third lever could be to scale carbon market ecosystems and enabling environments. This could include scaling project development and validation capacity on the supply side and securing advance market commitments on the demand side. These levers are unpacked in greater detail in sidebar, “Delivering on priority actions to drive private foreign direct investment.”

Increasing sovereign and private domestic resource mobilization

Sovereign and private domestic resource mobilization could be increased, one, by deepening capabilities in local financial sectors to improve the management and implementation of climate-related regulation and the use of finance instruments specific to climate, such as green or sustainability-linked bonds. Building a pipeline of bankable energy transition and climate projects could also be useful. Two, stakeholders could work to expand the tax base and align taxation to climate objectives, for instance, through implementing tax collection improvements or eliminating fossil fuel subsidies. The latter could take valuable resources away from cash-constrained public resources and discourage investments in energy-efficient technologies, making it more difficult for cleaner and renewable forms of energy to compete. Finally, stakeholders could consider restructuring sovereign debt, for example through debt-for-climate and debt-for-nature swaps, implementing climate innovations in sovereign debt instruments such as automatic interest moratoriums in the event of catastrophes, and reducing borrowing costs through measures to reduce country risk and increase sovereign bond liquidity through better-developed repo markets.

Transformative change is within reach

The window to stabilize the globe’s climate trajectory and limit global temperature increases is closing, so near-term results matter greatly for the future of vulnerable developing countries and the rest of humanity.

The good news is that climate action and economic development need not be a trade-off but can be mutually reinforcing. While the investment required for climate initiatives is significant, it promises to unlock new revenue streams and export markets for developing countries. These countries can also take a leading role in environmental stewardship. The alternative could see rising emissions and increasing environmental degradation in these regions as populations grow over the coming decades and climate change impacts increase.

There are many tools at stakeholders’ disposal, both internationally and in developing countries, to help narrow the financing gap before it is too late. By prioritizing collaborative efforts, innovative financing mechanisms, and inclusive policies that reward decarbonization, sustainable and climate-resilient development could be achieved. The opportunity for transformative change is within reach if we act boldly and act soon.