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From this perspective, climate finance would enable recipient countries to combine the efficiency of emission pricing policies with the pursuit of their pressing development objectives, most importantly poverty reduction.
 
Even though industrialized countries are responsible for the lion’s share of historical greenhouse gas emissions and display per-capita emissions considerably above the world average, ambitious climate targets can only be achieved if significant emission reductions also take place in developing and emerging economies. These countries are currently on a pathway to replicate the development, emissions and energy use patterns of today’s industrialized countries. As a consequence, measures that put them on a low-carbon development trajectory and avoid the build-up of carbon-intensive energy infrastructure feature prominently in the climate policy debate. Failing to do so would likely result in a lock-in of carbon-intensive infrastructure and hence emissions for the next decades, which would render decarbonization more difficult.
 
Given that poverty reduction is the dominant policy objective for developing countries, they cannot be expected to meet the additional costs of low carbon energy technologies required to reduce emissions – a principle which is enshrined in the UNFCCC principle of ‘common but differentiated responsibilities’. As a consequence, the international community has agreed to mobilize USD 100 billion annually to support climate measures in developing countries by the year 2020. By fostering the transition to a low-carbon society, these funds are intended to create synergies between emission reductions and economic development.
 
Even though the exact amount of financial flows that can be considered to be climate finance is heavily disputed due to a lack of a clear, unambiguous definition of the term ‘climate finance’, estimates suggest that financial flows currently amount to about $35–49 bn. The Green Climate Fund (GCF), which constitutes the main vehicles to mobilize climate finance, has received pledges of more than USD10 billion to be disbursed in the near future. In combination with the Adaptation Fund established under the UNFCCC, as well as schemes to provide insurance against climate-related impacts, the GCF can be regarded as a cornerstone of an emerging international climate finance architecture.
 
Discussions on the GCF have to date almost predominantly focused on the question how to raise the required financial means and how to account for donors’ contributions. By contrast, there are relatively few persuasive proposals on how to ensure that these funds are applied such that the implied policy objectives –climate change mitigation and adaptation, as well as sustainable socio-economic development– are pursued in an effective way.
 
For the case of climate change mitigation, the GCF board has outlined a list of priority areas, including energy generation and access, buildings and cities, land use, and transport, that are to be potential targets for climate finance. However, it is unclear how mitigation actions in these areas can effectively be incentivized. Many observers have questioned to what extent a project-by-project approach can be an effective device for large-scale climate change mitigation. Lessons from the Clean Development Mechanism (CDM) hint towards potential problems of project-based climate finance regarding additionality (i.e. determining whether a certain project would not have undertaken without the mechanism) and leakage (i.e. emission reductions in one area being at least in part compensated by increases in others). Furthermore, it seems questionable whether the CDM has contributed to objectives additional to climate change mitigation, such as technology transfer and sustainable development.
 
Recent literature has identified numerous ‘feasible mitigation options’ that would trigger emission reductions aligned with recipient countries’ development objectives, including e.g. clean-air policies, energy access measures, and public transportation. From an economic perspective, the most important policy to correct the greenhouse gas externality is putting a price on emissions, e.g. by means of a tax or a tradable permit scheme. In this manner, economic actors face an incentive to reduce their emissions in the most cost-efficient manner.
 
To date, carbon pricing is often seen as an inappropriate tool by developing countries - mainly because it increases energy costs and puts pressure on poorest households. However, carbon pricing constitutes a source of public revenue that is arguably less distortionary that taxing labor or capital. In addition, recent research by the World Bank emphasizes that putting a price on carbon requires a less sophisticated administrative system than alternative forms of taxation, and is less easily evaded (as, even if an activity carried out in the shadow economy, its associated energy consumption will be affected by the carbon price). Hence, getting the prices right for energy could not only improve environmental quality (in addition to other benefits, such as local air quality), but could also help to raise the means to meet financial needs to promote development. For instance, governments around the world currently spend more than USD 500 billion per year to subsidize the consumption of fossil fuels. This is not only harmful for the environment, but also a massive drain on public budgets. If these funds were invested in alternative ways, such as provision of basic infrastructure, important advances in the fight against poverty could likely be achieved. For instance, redirecting fossil fuel subsidies could help the majority of countries in Africa and South Asia to achieve universal access to water, sanitation, and electricity within a time-frame of about fifteen years. Likewise, emission pricing could raise significant amounts that could be used to close existing infrastructure access gaps, strengthen social systems and improve education and health-care, and foster climate change adaptation. As a simple example, consider a moderate emission price of USD 20 per t/CO₂. Such a price would raise almost USD 1 trillion globally, i.e. a magnitude above current development aid, which could be – at least partly – employed to promote sustainable socio-economic development.
 
Linking fossil fuel subsidy reform and emission pricing to investments in public goods would thus greatly reduce concerns that environmental quality is paid for by the poorest segments of the population. This approach would also be well aligned with the Sustainable Development Goal (SDG) agenda, which aims at promoting human well-being without undermining the integrity of the natural environment. Recent research by the World Bank and the IMF has identified criteria that can help to establish pro-poor climate policies. Based on these insights, climate finance can make a contribution to sustainable development by covering incremental costs of climate-related policies, facilitating technology transfer, capacity building and assisting in the implementation of schemes that compensate political losers.
 
By providing recipient countries with the flexibility to decide which emission pricing policies are appropriate in the national context and which measures are to be funded with the revenues, the approach outlined above allows for ‘ownership’ by recipients, which has proven to be of prime importance in development cooperation. That is, empirical evidence strongly supports the notion that those policies that are most closely aligned with national development objectives are the most likely to be successfully implemented. This approach could be operationalized by a competitive bidding process, in which countries propose intended measures to reduce emissions as well as the financing needs and capacity requirements to the governing board of the GCF or a comparable climate finance vehicle. The board could then allocate finance based on the merits of these proposals, facilitate knowledge transfer with regards to policy instruments and best practices, and engage in monitoring and peer-review of existing policies.
 
Climate finance could hence not only result in substantial emission reductions, but could also alter countries’ strategic calculations and promote international cooperation. For instance, adoption of emission pricing policies in emerging economies – incentivized by climate finance – could alleviate concerns related to competitiveness and carbon leakage in industrialized countries. These countries, in turn, would then have a higher willingness to either implement their own emission pricing policies, or strengthen existing pricing schemes, such that global emissions are further reduced as a strategic reaction.