| Abstract: |
Climate mitigation and adaptation require substantial investment to advance
sustainable development. In low- and middle-income countries (LMICs),
mobilising such finance is particularly challenging for small and medium-sized
enterprises (SMEs) due to persistent market failures, including limited
financial disclosure and weak credit-risk information. High upfront costs,
uncertain returns and weak regulatory frameworks further constrain adoption of
low-carbon technologies. While fiscal constraints and the capital-intensive
transition underscore the need for private capital, traditional bank financing
is restricted by long project horizons, high risk and macroeconomic
instability. Blended finance and guarantees are key instruments for mobilising
private investment in LMICs. Blended finance combines concessional public
resources with private or additional public capital to mitigate profitability
risks, while guarantees reduce perceived risk by covering partial losses,
particularly for non-commercial risks. This policy brief assesses their role
in scaling SME climate finance, alongside their limitations and
context-specific applicability. Evidence suggests that leverage effects,
especially for blended finance, are more modest than often assumed and are
context dependent; nonetheless, these instruments remain relevant for
de-risking SME finance, contingent on improved design and implementation. The
policy brief advances the following recommendations: - Financial
intermediaries should prioritise SMEs facing binding financing constraints
that prevent projects with clear socio-economic and environmental benefits.
Project selection should integrate financial and climate vulnerability, though
assessment remains difficult in low-income countries (LICs). De-risking
instruments should target specific constraints, with guarantees mitigating
risks and blended finance supporting projects with insufficient risk-adjusted
returns to attract private capital. Multilateral development banks (MDBs) and
development finance institutions (DFIs) should ensure additionality, minimise
concessionality and strengthen monitoring and transparency. - MDBs and DFIs
should better align donor incentives with effective risk-sharing and flexible
financing structures. Concessional senior loans dominate blended finance but
have limited loss absorption, reducing effectiveness in high-risk
environments. A more balanced mix, including subordinated debt, equity and
guarantees, can improve risk allocation and crowd in private investors.
Greater use of special purpose vehicles and off-balance-sheet structures can
further expand financing capacity in fragile contexts. - MDBs and DFIs should
strengthen coordination, standardisation and local engagement. Fragmentation
in blended finance and guarantees increases complexity and transaction costs
and deters institutional investors. Greater harmonisation across MDBs, DFIs
and private investors would improve capital allocation and complementarity,
while standardised procedures and contracts would streamline project
preparation and scaling in LMICs. Governments in LMICs should address
structural constraints, with MDBs and DFIs providing complementary de-risking
and capacity-building support. Weak investment climates, shallow financial
markets, poor project pipelines and weak credit information systems reduce the
effectiveness of blended finance and guarantees, particularly in LICs.
Governments should strengthen investment climates, deepen financial markets
and improve SME capabilities, while MDBs and DFIs support local intermediaries
and broader reforms. |