How the Climate Finance Puzzle Fits into the Global Financial System

At the heart of the world's economies is the global financial system - a set of institutions, markets and mechanisms that enable the flow of finance. But 21st century challenges, such as a global pandemic, international conflicts and especially the escalating impacts of climate change, are increasingly sending shocks through this system.

When the global financial system functions well, it provides the channels and rules that enable countries to interact with one another through trade, investment and other official transactions. In the past, it has also helped countries manage many economic, political and environmental shocks. But with pandemics, wars, debt and climate change all impacting the globe at once, questions about how to better stabilize the system are now appearing on agendas of international meetings.

The current Brazilian Presidency of the G20 includes the reform of global governance institutions as one of its three priorities, and many world leaders and thinkers are calling to reimagine the global financial system for modern times.

As UN Secretary-General António Guterres said in January 2023, "We can't build a future for our grandchildren with a system built for our grandparents."

This signals recognition that the global financial system is facing problems that require improved communication and cooperation. There's an opportunity - and perhaps a necessity - for some of this reform to support better climate and nature outcomes.

How the global financial system relates to the climate and to the United Nations Framework Convention for Climate Change (UNFCCC), the entity tasked with coordinating the world's response to climate change, is an ongoing debate. The economic and financial community and the climate community must tackle systemic issues together. Will they rise to the challenge?

Understanding the Role of the Global Financial System

Without the global financial system, money can't flow between people and countries. Central banks, commercial banks, financial markets, regulatory bodies and international financial institutions essentially act as the roads, railroads or infrastructure on which financial instruments, such as money flows and resources (the vehicles), are invested or passed along.

To account for shocks in the system or respond at times of crisis, a global financial safety net (acting as airbags) was gradually created to ensure the system remains stable and predictable.

For example, if a country's own reserves are not enough, other central banks can provide rapid liquidity, as the U.S. Federal Reserve did during the 2007-2008 financial crisis. And regional financial arrangements like the European Stability Mechanism or the Chiang Mai Initiative have been created to better pool resources. In addition, since 1944, the International Monetary Fund (IMF) provides financial capacity to stem crises occurring in member countries and prevent them from spilling over into other countries.

At the heart of the global financial system are the IMF and the World Bank Group. These two institutions are unique in that nearly all countries are represented through specific membership and governance arrangements (through various respective ministries or central banks).

When these institutions were created - at Bretton Woods 80 years ago after World War II - the global financial system wasn't set in stone. As the post-war world took shape and new countries were established or gained independence, institutions, standard-setting bodies and other entities emerged; over time, adjustments were made to respond to new types of shocks and accommodate change. Today, climate change is frequently becoming one of those new shocks to which the financial system must be prepared to respond.

The IMF and World Bank were created during a gathering of global leaders in 1944 at the Mount Washington Hotel in Bretton Woods, New Hampshire. Photo by travelview/iStock.

What Is the Relationship between the Global Financial System and Climate Finance?

There's no formal governance relationship between climate finance and the global financial system. But climate finance, whose principal objective is to address the impacts of climate change, must use the global financial system, which facilitates the flow of climate finance and allocates resources for climate-related activities. Whether it's a loan made by a development bank to build a solar farm, or a hurricane-battered country seeking payment for damages through sovereign insurance, these "vehicles" travel through the global financial system.

In the context of the UNFCCC, the importance of international climate finance - which originates with one country and funds climate action in a different, developing country - was codified in the 2015 international Paris Agreement on climate change.

The Paris Agreement's long-term finance goal is even broader and aims to align finance in all countries with global adaptation and mitigation goals. The Agreement also aims to facilitate the flow of finance to developing countries (via Articles 9.1 and 9.3).

The global financial system worked hard to make itself more resilient to unexpected shocks following the Asian Financial Crisis in the late 1990s and the 2007-2008 Global Financial Crisis. During this time, the UNFCCC, for the most part, remained outside of these discussions on managing economic and financial shocks. But conversations began to converge between the two communities, allowing for the global financial system to start integrating some climate considerations.

For example, in 2015, the Financial Stability Board (set up by the G20 in 2009 after the Global Financial Crisis) started to detail how climate could undermine financial stability through sudden megastorms, long-term droughts and the retreat of fossil-based economies. It established the Task Force on Climate-Related Financial Disclosures (TCFD) to study how climate risks impact finance (subsequently complemented by the Taskforce on Nature-related Financial Disclosures, TNFD).

Recommendations from those taskforces provide a concrete way to incorporate climate into investment decisions made within the global financial system: These disclosure regimes, which act like a streetlight system, illuminate paths of travel and point out risks or opportunities to investors along the way. Now, TCFD recommendations have been incorporated by the International Accounting Standards Board (IASB) that develops financial accounting standards, as the International Sustainability Standards Board (ISSB) builds on these standards that are becoming globally accepted.

The pressure for policymakers in the economic and financial spheres to address the challenges posed by climate change isn't just coming from white papers, disclosure frameworks and communiqués calling for action. Business leaders, policymakers and everyday people are recognizing that financial reforms are needed to allow societies to fully address these issues as they experience more severe and frequent climate impacts - which are disrupting and devastating lives and economies at national or regional scales - and as they see the need for investments which can support just transitions towards a climate- and nature-smart world.

Rows of solar panels soak up the sun in Cape Town, South Africa. Global financial reforms can help enable countries to raise and contribute more climate-related finance for expanding clean energy and other low-carbon solutions. Photo by Connect Images/Alamy Stock Photo

Why More Dialogue Must Take Place between the Climate and Finance Communities

Key stakeholders from governments, the economic and financial community, and the climate community must tackle systemic issues together, because effective solutions require the resources, perspectives and expertise of all sides. These systemic issues are characterized by three themes:

1) Climate change exacerbates development challenges.

Delaying climate action or not investing in mitigation and adaptation now will only worsen climate impacts and, in turn, jeopardize development outcomes. Many institutions include climate considerations in macroeconomic projections and analysis used for delivering policy advice, including the IMF, World Bank Group and other development banks, and country finance ministries (at the G20, the Coalition of Finance Ministers for Climate Action and the V20). This helps the global financial system ensure its "roads and infrastructure" function well.

Addressing climate-related development challenges requires investments into policies or projects such as green industrialization, decarbonization pathways and resilient infrastructure, so that sustainable development follows. However, most countries face significant barriers, ranging from lacking incentives to high debt, to making these investments now.

2) Climate change negatively impacts economic and financial stability.

There is no shortage of evidence to support the economic and financial costs of climate-related disasters. For example, the agricultural sector is regularly impacted by heatwaves and massive floods, which all too frequently result in loss of life, damage the environment that supports livelihoods, and wipe out substantial portions of national income. Fearing these climate impacts, investors and insurers are more likely to seek out safer locations with lower climate risks. This strains the global financial safety net, which must be strengthened to handle exacerbating macroeconomic and financial instability and risks due to climate change.

3) The sum of all currently available climate finance - public, private, domestic and international - is inadequate to meet Paris Agreement goals.

The Organization for Economic Cooperation and Development released data in May 2024 indicating that the $100 billion annual goal for climate finance was reached (albeit behind schedule), but that in the years ahead, climate finance needs will increase many times over. There simply isn't enough finance flowing to support countries' transition and adaptation needs, especially for developing countries who were not present to shape the building blocks of the global financial system.

While it has become certain through studies and experience that climate change could threaten the stability of the global financial system, and that greater flows of international climate finance are needed, it remains less clear what climate-related reforms are required from the global financial system. As mentioned above, the 2015 Paris Agreement did set out a long-term goal to "align" all financial flows with what would be needed to achieve global mitigation and adaptation targets; it did not, however, say exactly how this could be achieved. The first Global Stocktake of the Paris Agreement that concluded in 2023 revealed the need to significantly ratchet up "climate ambition," backed by finance for developing countries. This has triggered a mounting clamor from multiple stakeholders.

Calls for Global Financial System Reform to Enhance Climate Action

From the G7/G20, to IMF and World Bank annual meetings, to the UNFCCC climate summits, debates are ongoing about the role of different actors, institutions, financing instruments and various climate funds to better understand how the global financial system and climate action interact. Some of the common calls for reform include:

1) "Multilateral development banks need to step up"

The role of multilateral development banks was called out for the first time in a decision from the 2022 UN climate summit (COP27). One example includes a call for different levels of development banks (multilateral, regional, complementing national and subnational) to support country investments and transitions to build resilient economies and channel climate finance where it is needed.

In Washington, D.C., a sign advertising annual meetings of the IMF and World Bank. Recent years have seen increasing calls for international development banks like the World Bank to play a more active role in financing and supporting climate action. Photo by Kiyoshi Tanno/iStock

2) "More and better climate finance"

Access to climate finance across sectors and countries is a recurring issue. In 2023, the Global Stocktake notably called on different actors in the global financial system to support climate action, reiterating the importance of reforms in the multilateral financial architecture with the aim to provide more and better climate finance. It recognized the need for more climate finance, especially through grants, non-debt and concessional instruments. The use of innovative finance instruments, carbon markets and new forms of taxation are also cited as ways to pursue Paris Agreement objectives, as well as the recognition of the role of the private sector, policies, regulations and enabling conditions to reach the scale of investment needed.

3) "Understand and manage risks better"

The Global Stocktake also called for a better assessment of climate-related financial risks by governments, central banks, commercial banks and institutional investors. Investors need clarity, such that financing instruments are put to their best use, and that the "streetlight system" effectively supports mitigating risks and aligning investments to the Paris Agreement goals. To provide a clear streetlight system that illuminates climate risks, the global financial system can build on the network of existing institutions, both by creating and adjusting the standards and rules in a way that integrates climate and nature and by showing how high-integrity carbon markets can provide new ways to invest. This would allow finance to better enable and support countries' economic growth and development that is sustainable, low-carbon and resilient.

4) "Rewire the global financial system"

Further ideas have come from Barbados Prime Minister Mia Mottley, in the so-called Bridgetown initiative. This highlighted ways that development and international finance, among other structural features of the global financial system, can change to include climate and better reflect the composition of the global financial system and realities of countries today - rather than when it was created.

Other diverse coalitions of stakeholders, including countries, private and non-governmental entities, have rallied behind calls for reform. The V20 (a grouping 68 climate-vulnerable nations) launched the Accra-to-Marrakech Agenda, featuring four major suggestions for "rewiring" the global financial system to work for climate and particularly for climate-vulnerable countries. It includes suggestions on debt, carbon financing and risk management.

In particular, dealing with debt accumulation effectively and with distress in a timely manner requires institutions such as the IMF, the G20 (Common Framework), traditional and non-traditional creditors, borrowing governments and the private sector to work together towards finding solutions.

Other venues where initiatives were launched include the Summit for a New Financing Pact in Paris (June 2023), the Africa Climate Summit (September 2023), the Emergency Coalition on Debt Sustainability and Climate (October 2023), and, most recently, the African Development Bank annual meetings (June 2024). During these high-level gatherings, calls for reforming the way unsustainable debt is handled have multiplied, including in the context of international climate talks. But all stakeholders have yet to define and agree upon faster solutions.

The functions of the system are decided collectively over time by decision-makers. Any reforms need to be perceived as legitimate and owned by all stakeholders, be it borrowers, or all types of donors and finance providers working together. The inherent trust and solidarity mechanisms that legitimize the international financial system are being put to the test. Systemic elements can change to support the transition to a low-carbon and climate-resilient economy.

Several of these themes have been echoed at the margins of recent UNFCCC negotiations at COP27 in Sharm el-Sheikh and COP28 in Dubai, in an attempt to outline principles for global climate finance. These discussions highlight the connective tissue between climate and the global financial system, such as the provision of international climate finance for developing countries; the better management of climate risk; or investing into resilience while countries are debt constrained.

Ultimately, while the UNFCCC climate regime cannot singlehandedly drive changes in the global financial system, it matters that these conversations between the climate community and the economic and financial community are happening and that shared goals and effective means of achieving them are agreed.