The costs of using ‘climate finance’

One important tool in the fight against climate change is climate finance. Through both public and private sources, climate finance could potentially help reduce greenhouse gas emissions while increasing resilience against climate change impacts. Though not well defined, climate finance broadly refers to the cross-border financial flows mostly from the developed countries to developing countries. The mechanism currently used to transfer funds is considered risky due to discrepancies in financial information reporting and sharing in different countries, the difficulty of implementing contracts at the international level, and uncertainties over recipient capacities and outcomes. While these risks are mitigated through involvement of bi-lateral and multi-lateral agencies, these agencies also increase the transaction costs and limit the strengthening of institutions in developing countries.

To better understand these challenges and identify more effective transfer mechanisms, a team of researchers has analyzed the role of transaction costs and how it varies based on the selection of institutional and governance structures. Also, the researchers — from Potsdam Institute for Climate Impact Research, Germany and KfW Development Bank, Germany — review drivers and incidences of transaction costs in reference to the state-to-state climate finance. Their findings were published in the journal Global Environmental Change.

The author's descriptions are based on "new institutional economics" (NIE), an economic approach that combines different actors related to a variety of institutions such as social, legal, structural and political. In particular, it focuses on the cost of establishing and using an institution, which is referred to as the transaction cost.

Many institutions at different levels of governance directly affect mobilization of climate finance. Therefore institutional efficiency in delivering financial support to the local level is an important factor. Cost minimization not only depends on the technological innovation but also on institutional innovation. However, due to a lack of contract enforcement between states and high uncertainty in international relations, transaction costs tend to increase. Several types of transaction cost exist and many of them are difficult to measure. In climate finance, the most common type of transaction cost is the operating cost of organizations. 

There are two main drivers of transaction cost: weak institutional structures and a lack of information-sharing among states involved in climate finance. According to researchers, uncertainties can be reduced if climate finance contracts establish an enforceable claim towards receiving payment for a specific purpose over a defined period of time. Unfortunately, due to unclear legal provision no reliable institutions exist to achieve this. Moreover, international climate finance is not specifically defined and lacks no agreed definition in many aspects.

The technologies employed and the institutional structure utilized in climate finance drive total costs. Transaction costs have many facets and they increase along with uncertainty among transaction parties. Researchers say transaction costs can be reduced through direct transfer to the budget of the recipient government. To facilitate direct transfer efficiently institutional capacity is required. However, the creation of new institutions drives up costs. The current model of donor-driven delivery of projects can increase the administrative costs on recipients and also would not allow its institutions to gain experience to manage climate finance. Hence, there is need for significant institutional innovations to address such oppositional forces. More positively, there is hope that considering these costs while undertaking economic assessments could promote better policy by providing policy makers with realistic cost estimates.