Managing Currency Risk to Catalyze Climate Finance

Currency risk is a critical obstacle to scaling climate finance in emerging market economies, according to this paper by the Climate Policy Initiative (CPI). The authors – Zeineb Ben Yahmed, Chris Grant and Nicole Pinko – emphasise the urgent need for expanding local currency lending and affordable hedging mechanisms to reduce capital costs and unlock climate finance.

Emerging markets and developing economies (EMDE) require approximately US$2.4tn annually in climate finance by 2030, with domestic markets only able to provide around half of this amount under current conditions. While strengthening macroeconomic conditions and deepening local financial markets are the most effective long-term solutions, the financing gap must be at least partly filled by international sources in the near-term, state the authors.

However, currency risk arising from the mismatch between hard currency debt and local currency revenues poses a major challenge, particularly for renewable energy projects which have long lifespans, high upfront capital needs, and produce revenues in local currencies.

When local currencies depreciate, it increases debt repayment costs, threatening project viability and debt sustainability. Hard currency sovereign borrowers may be forced to allocate more fiscal resources to support struggling projects and service associated debt. This is particularly concerning “given that foreign currency lending makes up about 70-85% of low-income countries’ debt”.

The paper’s analysis identifies two key hurdles for EMDEs seeking sustainable financing for climate projects: the lack of affordable, long-term local currency lending and the high costs of commercial hedging products. Hedging costs can add 6-7 percentage points to foreign currency loan costs for EMDEs, often negating the benefits of lower interest rates on hard currency loans.

Investors’ perceptions of currency risks in emerging markets also tend to exceed actual risks. According to the authors, this further increases the cost of capital and commercial hedging products, driving demand for even higher returns and deterring investment. For instance, a CPI analysis found that a solar project in the EU may require an 8% return, compared to 22% for similar projects in major EMDE markets.

Together these factors feed a self-reinforcing cycle where a lack of financially sustainable investment further weakens local currencies and financial markets.

The report examines five innovative approaches to mitigate currency risk which are at various stages of development.

1. A donor-funded guarantee facility: a mechanism to absorb part of the losses incurred by The Currency Exchange Fund when providing foreign currency hedging products to countries that are typically excluded from commercial hedging, allowing for below-market rates for climate projects.
2. Eco Invest Brasil: a partnership between the Brazilian government and the Inter-American Development Bank which includes a long-term FX liquidity component to support climate projects capable of increasing local currency revenues in line with inflation
3. Delta: a onshore development bank hedging proposed platform that would borrow local currency from multiple sources on a short-term basis, a portion of which would then be lent to development banks over longer terms, using the excess as a buffer to manage associated currency risks.
4. Multilateral development bank (MDB) transfer mechanism: a proposal  from FSD Africa to sell established loan portfolios from MDBs to local investors, freeing up MDB capital for new climate lending in local currencies.
5. Climate Policy Initiative’s FX Hedging Facility: a proposed mechanism to manage currency risk for renewable energy projects by dividing depreciation risk into tranches allocated to different stakeholders.

Each solution has unique strengths, limitations and trade-offs with many relying on concessional and/or donor capital to absorb tail risks, which could be seen as a threat to long term financial viability.

The report also notes that the climate-focused proposals primarily target high-emitting emerging economies with more developed financial markets. This highlights the importance of long term financial market development as well as tools that address the immediate currency risk-related needs of the lowest income countries.

The authors suggest areas for future research and policy work, including enhancing affordability of hedging instruments, developing local currency bond markets, promoting risk-sharing and developing blended finance approaches that work for EMDEs. They emphasise the need for collaborative, nationally-tailored solutions and advise MDBs to expand local currency lending and provide technical assistance.