Solving the climate finance equation for developing countries

| Article

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.1The 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.2

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 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

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.5 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.6

Developing countries are most vulnerable to global climate impacts.

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 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 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 Projections indicate further increases in such climate-related incidents, likely leading to a broad range of social and economic impacts.10

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 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 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.13

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 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).

A green growth agenda could deliver significant socioeconomic benefits in Africa.

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.15

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 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

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”).

Would you like to learn more about our Sustainability Practice?

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.18

About $2 trillion per annum of additional climate financing is needed by 2030 for developing countries.

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 2030.19 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.20

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”).21 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.22 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.23

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 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.25

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.26 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 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.28 This could close 20 to 30 percent of the climate finance gap after potential increases in domestic resource mobilization are accounted for.29

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 2022.30 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.31 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).

Nine levers could catalyze more climate finance in developing countries.

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 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.33 In previous research, McKinsey has laid out the potential for philanthropy to drive catalytic investments, take risks, and innovate in climate finance.34

Enabling more private foreign direct investment

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.

Explore a career with us