Bridging the $1.3 trillion climate finance gap: a pragmatic agenda for emerging markets

Luiz Awazu Pereira da Silva and Fernanda Gimenes propose a sequenced and pragmatic reform agenda to help close the US$1.3 trillion annual climate finance gap for emerging markets and developing economies by 2035. The agenda connects regulatory, institutional and technological reforms across the financial system, showing how each component can lower risk premiums, unlock investment and make climate finance both viable and scalable.

It is an old debate in international macroeconomics: global savings do not naturally flow to emerging markets and developing economies (EMDEs), where returns to investment are higher and the need for capital is greater than in advanced economies. EMDEs are constrained by perceived risks, persistent home bias and deep structural asymmetries in the international financial system. This creates a double paradox that has evolved since the global financial crisis.

Reversal of the paradox

In the 2010s, EMDEs faced a post-financial crisis paradox. Under very low interest rates and unconventional monetary policies in advanced economies, they experienced excessive and volatile short-term capital inflows. These ‘sudden floods’ of capital, often driven by global liquidity cycles rather than fundamentals, triggered credit booms, asset-price volatility and episodes of financial instability.

Today, the paradox has reversed. EMDEs urgently need stable, long-term, risk-taking capital to finance climate change adaptation and mitigation investments, yet they face reluctance across the financial system – from investors constrained by current regulation and risk metrics, to credit rating agencies, reserve managers and institutional mandates that reinforce home bias. When global conditions tighten, these same channels trigger ‘sudden stops’, cutting off flows just as they are most needed. Instead of too much short-term money, they now receive long-term financing that is too little and arrives too late to meet the scale of their climate and development needs.

The root causes are well known. Global financial risk metrics and regulatory standards remain biased towards advanced economy benchmarks. The international monetary system is still dominated by the US dollar, while most EMDEs suffer from ‘original sin’: they cannot issue safe and liquid assets in their own currency. This structural hierarchy, reinforced by monetary dominance and market myopia in advanced economies, continues to shape global capital flows.

As a result, cross-border climate finance to EMDEs remains a fraction of what is needed. Our analysis shows that to stay on track for net zero, these countries – excluding China – require around US$2.4 trillion in investment every year, of which roughly US$1 trillion must come from external sources. Yet actual flows cover only a small share of that need. Without a major effort to mobilise and align international capital, the global transition will stall where it matters most: in the economies that hold two-thirds of the world’s population and most of the growth in emissions.

The self-reinforcing trap

Today’s financial architecture unintentionally penalises green investment in EMDEs. Prudential rules under the international bank regulatory framework Basel III treat long-duration assets – including renewable energy and resilience infrastructure – as riskier than short-term or advanced-economy exposures, forcing banks to hold more capital against them. Sovereign-rating methodologies amplify risk premiums rather than recognising the stabilising role of the multilateral development banks (MDBs). Foreign-exchange risks are magnified by scarce long-tenor hedging instruments. Fragmented taxonomies, incomplete disclosures and mandates that keep investors close to home or within investment-grade limits compound the problem.

The result is a vicious circle. High perceived risk deters investment; limited investment reduces market depth; shallow markets confirm the perception of risk. Breaking this loop requires reforms that both reprice risk and expand risk-sharing mechanisms.

Rethinking prudential and supervisory rules

The first pillar is prudential reform. The Basel III framework was designed to curb the financial exuberance and instability that led to the global financial crisis. Its objective remains vital, but the framework’s current calibration misprices climate-related risks in EMDEs.

A modernised approach should:

• Integrate forward-looking climate stress tests into supervision.
• Converge taxonomies and align disclosure standards with the International Sustainability Standards Board (ISSB).
• Recalibrate capital, liquidity and leverage rules so that properly structured MDB guarantees and long-term green assets are no longer penalised.

This does not mean diluting prudential discipline: it means updating the rules to distinguish between greenwashing and genuine risk-mitigation instruments that deserve capital relief.

Central banks and reserve management

Central banks can also use their monetary and reserve toolkits more flexibly – without compromising their mandate or credibility. They can make high-quality green assets eligible as collateral, explore rigorously designed green-asset purchase programmes, and consider limited diversification of reserves into pooled green-bond vehicles. These steps, if communicated transparently and implemented sensibly, would help create the deep and liquid markets that climate-aligned finance requires. And in a world of growing potential uncertainties about US policies and possible volatility in the US Treasury market, a measured diversification of reserves could become a reasonable and prudent strategy for many central banks.

Reforming MDBs and unlocking institutional capital

MDBs remain uniquely placed to catalyse private investment, but their balance sheets and governance constrain that potential. Capital increases are necessary, but so is the recognition of callable capital, which would multiply their lending capacity without undermining ratings. Lower internal capital charges for guarantees, and a consistent recognition of MDB risk-sharing within Basel III and by credit rating agencies, would make these guarantees far more effective.

Institutional investors – sovereign wealth funds, pension funds and insurers – manage around US$180 trillion in assets. Redirecting even 0.5 per cent of these portfolios could provide the US$650 billion in private flows that EMDEs need each year, our analysis shows. But to do so, investors require clear taxonomies, investable pipelines and credible credit enhancements. Regulatory changes that adapt non-bank rules, encourage special-purpose vehicles (SPVs) for green bonds and expand FX-hedging and local-currency facilities could turn this potential into reality. Right now, equity investors can rely on decarbonised financial indices that can play a catalytic role in mobilising capital for the net zero transition by reorienting portfolios towards low-carbon firms without sacrificing diversification or returns.

Building the digital backbone

Financial technology can reduce friction and cost. Artificial intelligence can automate reporting and improve data credibility. Tokenisation and distributed ledger technology (DLT) can make cash flows traceable and facilitate the aggregation of small projects. Smart contracts can trigger automatic disbursements or parametric insurance payouts. And multi-CBDC [central bank digital currency] and real-time FX settlement platforms can shrink convertibility and settlement risks. Used prudently, these tools can make green investment in EMDEs more transparent, liquid and efficient.

A coordinated, sequenced approach

No single reform will close the gap. Progress requires sequencing and interoperability among prudential regulators, central banks, MDBs, investors and fiscal authorities. A ‘coalition of the willing’ can start implementing these changes even before universal consensus is achieved, provided reforms are recognised consistently across jurisdictions.

Crucially, these efforts must not erode the core principles of prudential soundness. We must avoid the temptation to introduce hastily designed ‘green’ exemptions that could weaken Basel III safeguards. The challenge is to redirect incentives without undermining stability.

A feasible roadmap

According to our recent analysis, if implemented together, the reforms sketched out above could mobilise the US$1.3 trillion in annual external finance that EMDEs need by 2035, broken down as follows

• $650 billion from private capital through risk-adjusted institutional investor participation
• $300 billion from MDBs via balance-sheet optimisation and capital reforms
• $100 billion from bilateral sources
• $50 billion from South–South cooperation
• $200 billion from concessional and innovative mechanisms – such as climate-fund replenishments, debt-for-nature swaps and international solidarity levies.

Reaching these numbers is not a fantasy. It is a question of policy coordination and political will.

Beyond finance: the macroeconomic foundation

Unlocking climate capital is not just about financial plumbing. It depends on climate-consistent adaptive macroeconomic frameworks that mobilise domestic resources while maintaining debt sustainability and social cohesion. In the ‘Green Swan’ era of severe, frequent supply shocks, fiscal policy must use climate-adjusted debt-sustainability analyses and treat green spending as growth-enhancing, while protecting credibility through transparent, time-bound rules. Monetary policy through adaptive inflation targeting must recognise climate-related shocks as structural, not cyclical. Together, these policies can provide the stable environment needed for reform and attract both domestic and foreign investors.

The bigger picture

Bridging the climate finance gap requires two inseparable dimensions: international coordination, to align incentives among G20 members, international financial institutions and MDBs; and domestic legitimacy, to ground fiscal and policy reforms in fairness and public trust. Only when both dimensions advance together can the transition to a low-carbon world gain momentum.

With climate finance high on the global agenda, upcoming forums offer key opportunities to turn ideas into action, including the Circle of Ministers of Finance, G20, IMF–World Bank meetings and COP30 in Belém. Expert groups such as the Paris Pact for People and the Planet Eminent Persons Group (4P EPG) and International High Level Expert Group on Climate Change (IHLEG), along with coalitions like the European Climate Foundation (ECF), Climate Policy Initiative (CPI) and Glasgow Financial Alliance for Net Zero (GFANZ), are aligning around a shared vision for reform. Civil society and youth organisations must also play their part to ensure accountability, legitimacy and intergenerational fairness.

The task is urgent but achievable. The world has the tools, the capital and the knowledge. What remains is to synchronise incentives, scale up reforms and act decisively before the financing window closes.

The views in this commentary are those of the authors and do not necessarily represent those of CETEx senior management or its funders. Any errors or omissions remain those of the authors. 

A CETEx discussion paper, ‘Unlocking climate capital for emerging markets and developing economies: an adaptive regulatory and policy reform agenda’, by Luiz Awazu Pereira da Silva, was published today at https://cetex.org/publications/unlocking-climate-capital-for-emerging-markets-and-developing-economies-an-adaptive-regulatory-and-policy-reform-agenda