Closing the Climate Financing Gap: New Proposals and Emerging Risks

As an increasing number of research projects and reports are underlining the need to contain global warming within 1.5 degree Celsius, it is ever more important for the international community to increase their efforts to mitigate and adapt to climate change. Thankfully, global leaders decided to reaffirm their commitments to the 1.5 degree goal at the Sharm el-Sheikh Climate Change Conference (COP27), held from November 6-18, 2022. Furthermore, major powers such as the European Union, the United States and China—as well as multilateral organizations such as G20, ASEAN, the Alliance of Small Island States, African Union and the Vulnerable 20—have all announced additional pledges, proposals and/or action plans to address climate change. As the international community turns to market mechanism ideas to address climate change, these proposals can lead to unintended and counterproductive impacts despite their potential. Accordingly, global leaders and stakeholders should carefully evaluate and implement new initiatives to ensure effectiveness and avoid emerging risks.

The recent global uptick in climate commitments belies a potentially expanding gap in climate-related investment and financing. According to the Intergovernmental Panel on Climate Change (IPCC), an annual average investment of around US$2.4 trillion is needed in the energy sector alone to reach the 1.5 degree goal. In contrast, many developing countries have not recovered economically to their pre-pandemic level, and low-income countries are now cutting public investment critical for long-term sustainable development. As the impacts of climate change intensify, the amount of funding needed for climate adaptation will also drastically increase. Despite promising developments such as the new climate reparation fund and a number of North-South cooperation initiatives, it is unclear whether vulnerable communities and countries will have sufficient resources to respond to climate change impacts and risks. 

As public funding and aid can be insufficient to close the financing gap, global leaders are now increasingly eyeing market mechanisms to incentivize contribution from the private sector. Just as the United States announced the Energy Transition Accelerator in early November 2022 to catalyze private climate financing by allowing developing countries to sell carbon credits to private companies that can “offset” the companies’ carbon emissions, the Africa Carbon Markets Initiative also aims to advance sustainable development by expanding Africa’s carbon credit market, potentially between the region and private companies worldwide. At the same time, countries at the forefront of climate change mitigation are now worried about “carbon leakage”: as a country sets higher environmental and carbon emission standards, companies are prone to move their production and operation elsewhere, leading to trading disadvantages and less effective emission reductions. Accordingly, the European Union has planned to implement a Carbon Border Adjustment Mechanism (CBAM); a de facto carbon tariff for certain imports from non-EU producers who have not “already paid a price for the carbon used in the production.” 

The idea of similar “carbon adjustment” tariffs has also attracted bipartisan interest in the United States. More recently, the U.S. has reportedly proposed to establish an “Global Arrangement on Sustainable Steel and Aluminum” along with the European Union to jointly impose carbon tariffs against steel and aluminum products that are produced in carbon-intensive ways. This particular arrangement is described as an effort to “level the playing field.” 

Despite good intentions, legitimate concerns and promising prospects, the above-mentioned initiatives and proposals must be carefully implemented to ensure effectiveness. In contrast to the potential of carbon credits, carbon markets are still at an early stage of development at both the national and regional levels. As emissions trading schemes (e.g., in the European Union and China) are still exploring the best way to ensure accuracy, reliability and accountability in the counting, verification and trading of carbon emission reductions within their own economy, the concerns for greenwashing—namely, that companies will misrepresent or exaggerate their contribution to climate change—have persisted. These issues will only be highlighted when initiatives such as the Energy Transition Accelerator and Africa Carbon Markets Initiative allow carbon credits to flow between the developing countries and the private companies around the world. This is especially important when said private companies are incorporated in economies that do not have a carbon market (e.g., the United States). 

To avoid a global race to the bottom, the international community should at least establish a global coordination and monitoring mechanism, such that best practices are shared and incorporated across different initiatives. Ideally, the individual initiatives should eventually lead to a global carbon market, aiming at genuine and measurable carbon emission reduction progress to jointly contain global warming. 

Notwithstanding the urgent need for global cooperation on climate change actions and market mechanisms, recent developments in “carbon tariffs” could shift the narrative from international cooperation to geoeconomic tensions. As the United States proposes to establish a “climate club” with the European Union and other like-minded partners to jointly impose carbon tariffs against non-members, researchers have found that punitive climate tariffs could inflict significant damage on the economies of others as well as global trade but might not effectively induce further emissions reductions unless non-members of the climate club are forced to join the club. As many developing countries are still struggling to find sufficient resources to invest in climate change mitigation and adaptation, such measures can potentially be counterproductive to global sustainable development and, accordingly, the global fight against climate change. Additionally, the introduction of punitive tariffs risked violating the rules of the international economic order and would erode trust in the global system for sustainable development—trust that has already been tested by the U.S. withdrawal from the Paris Agreement in 2017 and the increasing tensions between the United States and China. 

As the international community reaffirms its commitment to climate change actions, global leaders should give careful consideration to the measures that they seek to implement in addressing the climate financing gaps. Effective actions in the progression of sustainable development require not only the effective incorporation and coordination of all countries and stakeholders but also the genuine attention to effectiveness, accountability and the building of trust. 

This commentary was written as part of the BCCC Program Quarterly newsletter’s 2022 Q4 Theme of the Quarter: Global Uptick in Commitments to Climate.