Environmental Finance for Pro-Poor Development - Analysing the Role of Carbon Finance

31 Dec 2010


Against the backdrop of debates on the ability of carbon markets to improve access of the poor to energy, the report highlights the need to link pro-poor energy interventions to carbon markets by involving environmental, financial and institutional mechanisms.

In the backdrop of an intensified debate on climate change and a wider consensus on finding action oriented solutions, the emphasis on carbon markets in any post- 2012 climate policy agreement has become vital. Though the current economic downturn and absence of clear policy signals have raised concerns over the stability of carbon markets, an argument on the ‘failure’ of these markets to deliver sustainable development, has continued to linger. This report attempts to highlight the need for linking pro-poor energy interventions with carbon markets by involving environmental, financial and institutional mechanisms.

It is widely accepted that energy and development are intertwined. Estimates indicate nearly 1.5 billion people in the developing countries do not have access to electricity and nearly 3 billion people use traditional energy carriers for meeting their cooking energy needs. In this scenario, setting up carbon markets under the Kyoto Protocol was expected to provide access to low cost financing which could also be used for improving access to clean energy options. Similarly, projects addressing the Millennium Development Goals (MDGs) were expected to reduce poverty in developing countries. However, the existing carbon market mechanisms and MDG funds have come under severe criticisms for their inability to address the core issue of technology transfer and small-scale projects, especially those which cater to local environment and development benefits. The growing scientific evidence of diverse impacts of climate change demands that alternative environmental, financial and institutional mechanisms be created or modified to address both small scale mitigation and adaptation projects which enable enhancing access to modern energy for the rural poor.

Although the access to energy is not an MDG in itself, the adequate provision of energy is crucial for improving livelihoods. While the current contribution of carbon markets to improving the poor’s’ energy access appears to be limited, new projects with a potentially larger contribution to sustainable development, such as energy efficiency improvements in rural households or rural renewable electricity generation, are gaining ground. Carbon finance can work for pro-poor development provided appropriate mechanisms are created for cross-linkages with poverty reduction funds. This would require some fundamental focus as discussed below.

Infusing Investments

One of the most critical constraints in enabling energy access to meet both developmental and environmental agendas is the lack of adequate financial resources. Investments in energy for development projects, mainly coming from multilateral sources, have recently declined. Even private sector investments are channelled through the infrastructure sector supporting supply side generation, but the demand side projects are not a favoured choice. Although globally investments in clean energy are on the rise, they still require innovative financing options:

1) Making better use of private investment, aid and grants, micro financing schemes, and Foreign Direct Investments. Critical aspect is role of government in enabling public and private energy infrastructure development.

2) New sources of capital through carbon funds to make energy technologies available to meet energy demands.

Incentivising Technology Functionality

While carbon markets do create an incentive for keeping a system functioning, the upfront costs of the system remain a key barrier. The big question here is can the carbon markets address the upfront costs, as the inherent problem of existing mechanisms are such that they further enhance the upfront cost of technology/project.

In order to overcome these, following options can be explored:

1) Poverty reduction funds under the MDGs to fund a switch to energy efficient technologies and renewable energy interventions. This would assist in bridging the gap in technology cost.

2) Carbon financing as a mechanism in the form of payment for delivering environmental services, incentivising technology functionality.

3) Pre-payments for upfront costs, especially for the small-scale clean energy projects.

4) Income-generation activities can be boosted through auxiliary activities linked to carbon credit projects such as marketing and repair and maintenance services. In the case of community based projects this could involve afforestation and reforestation activities.

5) Involvement of social entrepreneurs for scaling-up clean energy projects have gained traction and needs infusing investments in promoting these local entrepreneurs through different financing options including pre-payments from carbon finance.

Reforming Carbon Markets

While the current contribution of carbon markets to improving the poor’s access to energy appears to be limited, new projects with a potentially larger contribution to sustainable development, such as energy efficiency improvements in rural households or rural renewable electricity generation, are gaining importance. Nevertheless, within the overall project portfolio, the contribution of carbon markets to meeting sustainable development objectives will probably remain low unless there are cross-linkages with poverty reduction funds. Given that there is a growing awareness of certain flaws in the current CDM, there are increasing pressures for a revamp in the post-2012 architecture. This will require exploring ways of putting:

1) A greater emphasis on the sustainable development benefits of individual projects, such as by placing a financial value on sustainable development (including making poverty reduction an integral part of the objective) and reflecting development in the price of carbon.

2) Focus on programme based activities rather than project based activities to enhance the scope of carbon markets.

3) A future aspect of post-2012 carbon market possibly could limit itself to carbon dioxide and methane mitigation projects, thereby emphasising on renewable energy and energy efficiency projects, including small-scale projects. This would assist in addressing development and poverty reduction challenges faced by developing countries.

An interim phase

Leading up to 2012 where institutions such as UNDP can play a pivotal role by leveraging and establishing a funding mechanism, which demonstrates efficacy of such approach by:

1) Raising awareness through a multi-stakeholder engagement process on the role of carbon financing for small-scale projects.

2) Establishing a small-scale carbon facility fund by bringing in investment from diversified sources.

3) Creating appropriate institutional mechanism for hosting of such funds and technical review.

4) Creating a basket of financing options to meet problems of upfront costs by leveraging with carbon credits.

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