Authors: Erica Atieno, (ACTS) , Lindah Fatuma, (ACTS) and Deborah Murphy, (IISD)

Climate change is one of the main global challenges against sustainable development with experts warning of grave consequences for vulnerable populations in developing countries who face the harshest threats and, therefore, likely to suffer disproportionately because of its negative effects.  

This trend is projected to continue taking a heavy toll on development prospects of most African countries. Significantly, the impacts of climate change have far-reaching and direct implications across all sectors of the economy, including food security, human health, and biodiversity (Das et al.,2020). Thus, the dependence of African economies on climate-sensitive sectors, particularly agriculture and natural resources, coupled with low adaptive capacity and high poverty levels makes the continent prone and highly vulnerable to the adverse effects of climate change. (Thornton et al.,2006).

Adaptation is one of society’s primary options for dealing with climate change. As temperatures rise and the effects of climate change worsen, nations must act quickly to adapt to the new climate reality or face significant costs due to the impacts of climate change. A significant amount of resources and coordinated efforts among different stakeholders ranging from the public sector to the private sector is required to address these challenges. So far, multilateral development banks (MDBs) are the prominent public sources of public adaptation financing for developing countries (USD 14.9 billion in 2015-16); followed by the relatively small contributions of bilateral donor governments and their agencies (USD 2.4 billion in 2015-2016) and the financial mechanism of the United Nations Framework Convention on Climate Change (UNFCCC), including the Green Climate Fund and Adaptation Fund (USD 0.4 billion in 2015-2016) (Tall, et al., 2021).

Although public finance is crucial in the implementation of adaptation efforts, private sector sources of funding are required to supplement and close the adaptation funding gap especially in light of the limited public resources (CIF, 2016).  Participation of the private sector in adaptation financing in developing countries is still relatively lower than it is in developed countries due to concerns on bankability, limited capacity and high risks of investments.

The most common financial instruments that have been used in climate finance include grants, concessional and non-concessional loans. Apart from these traditional financing approaches, there is need to utilise a variety of innovative climate finance instruments that overcome common risks, close market gaps and address some of the concerns that hinder the private sector from financing adaptation actions. Innovative financial instruments have special features that can help developing countries fill the adaptation funding gap by:

1. Mobilising additional public funding e.g. through imposition of taxes and levies;
2. Mobilising additional private funding e.g. through public private partnerships or blended financing, and
3. Enhancing efficiency in financial flows, such as through the use of result-based financing and output-based aid subsidies.

Innovative Financial Instruments: A Case Study of Kenya Microfinance Water Service Project

At the forefront of improving knowledge of innovative financial instruments to scale-up investments in adaptation in developing countries, the African Centre for Technology Studies (ACTS) recently explored the potential of innovative financial instruments in financing adaptation through a 3-year project - Mobilizing Development Finance for Strategic and Scaled-up Investment for Climate Change Adaptation - funded by the International Development Research Centre (IDRC) in partnership with the International Institute for Sustainable Development (IISD).

Through the project, ACTS documented success factors, challenges and key lessons for replicability and scalability on the use of innovative financial instruments for climate change adaptation in developing countries focusing on  Kenya Microfinance Water Service project. The project utilised a blended financial approach that involved a strategic mix of financial instruments – grants, credit guarantees, output-based aid (OBA) subsidies and loans – to finance rehabilitation and establishment of water infrastructure in the rural and peri-urban areas. The project aimed to enhance access and increase efficiency to water supply to enhance the adaptive capacity of communities to climate change. The blending of financial streams leveraged commercial financing from the private sector to improve the risk-return profile of the initiative. Multiple sources of funds bridged the gap between the supply and demand of private finance, a key challenge that exists in adaptation financing (Fayolle et al.,2019).

However, the project experienced four key challenges as outlined below:

• Limited capacity by the local banks to handle project financing;
• Limited bankability of loan applications;
• Governance issues in terms of leadership wrangles in managing the community water projects;
• Competition from other service providers whereby the local authority argued that water should be a free service without considering the sustainability of the projects.

On the other hand, several factors enhanced the success of the project:

• Blending of finances which enabled utilisation of multiple sources of funds, such as community equity, a commercial loan, and OBA subsidies, which encouraged the mobilization of domestic financing;
• A risk mitigation instrument in the form of a partial credit guarantee scheme provided some degree of comfort to the lender;
• Consumer willingness and ability to pay for services which enabled selection of viable projects that could sustain themselves in the long run; Provision of technical assistance to the projects for project development and implementation support.

As a result, due to the above success factors, the project enhanced access to and efficiency in water supply services in 35 water projects, reaching 190,119 beneficiaries as of February 2013 and a positive economic rate of return of US$2-US$10 for every US$1 invested (GPOBA,2015). Indications also pointed to a high potential of the project being replicated in other subnational and national jurisdictions.

Replicability and Potential for Scalability

The project was later scaled up with additional funding from the European Union which clearly demonstrates its replicability and scalability potential in other developing countries and other sectors of the economy. The blending of finances and the results-based financial approach through the use of subsidies has been adopted by various projects and commercial banks. This demonstrates its potential to be utilised in other African nations to help unlock private sector investment in adaptation financing.

To enhance successful replicability and scalability of the model in other countries, it would be important to build the internal capacity of commercial banks and other institutions where gaps exist, de-risk adaptation investments through the use of incentives such as subsidies and credit guarantee schemes, align policy frameworks with adaptation investments and invest in data and knowledge sharing to create awareness and enable investors to make informed decisions.

References

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• Thornton, P., Jones, P.G., Owiyo, T.M., Kruska, R.L., Herrero, M., Kristjanson, P., Notenbaert, A., Bekele, N., Orindi, V., Otiende, B., Ochieng, A., Bhadwal, S., Anantram, K., Nair, S., Kumar, V., & Kulkar, U.  (2006).  Mapping climate vulnerability and poverty in Africa. Report to the Department for International Development submitted by ILRI, TERI and ACTS.
• Climate Investment Funds (CIF). 2016. Private Sector Investment in Climate Adaptation in Developing Countries: Landscape, Lessons Learned and Future Opportunities.  
• Fayolle, V., Fouvet, C., Soundarajan, V., Nath, V., Acharya, S., Gupta, N., & Petrarulo, L. (2019). Engaging the private sector in financing adaptation to climate change: Learning from practice. Action on Climate Today Learning Paper, February.
• Global Partnership on Output-based Aid (GPOBA). (2015). Kenya Micro-Finance for Water Service Project - Kenya. Project completion report. GPOBA, World Bank.
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