Increasing LDC Access to "Climate Finance" and the Fungibility Hypothesis
A New Test of An Old Idea from Econ 101
Economists like to draw budget constraints. Such budget constraints allow us to display the consumption opportunities that a person can afford. Suppose that a person has $100 to spend and the price of rice equals $2 and the price of beer equals $1. Note that this person can afford 40 rice and 20 beer. She can also afford 30 rice and 40 beer. She can choose her favorite affordable bundle. Suppose she chooses to consume 20 rice and 60 beer. Note that this uses all $100 of her money
Now suppose that a benevolent outsider wants her to consume more rice because such consumption will make her children stronger. The benevolent outsider offers a 50% subsidy for rice consumption. This subsidy reduces the price she pays for rice from $2 to $1.
So, she now has $100 to spend on rice and beer and she faces the same price of $1 for rice and beer. In Econ 101, we would graph her budget constraint before and after the subsidy is offered and note the following point.
The subsidy for rice induces a substitution and an income effect. The recipient of the subsidy has a price incentive to consume more rice but she is now effectively richer and may consume more beer.
She originally chose to consume 20 rice and 60 beer when her Income =100 and the price of rice =2 and the price of beer=1.
She could afford to consume 20 rice and 80 beer when her income =100 and the price of rice =1 (due to the subsidy) and the price of beer=1.
If her intensity of preferences for beer is strong enough, she may choose to increase her beer consumption!
Why do I raise this econ 101 lesson? Read this piece about expanding “Climate Finance” in the Developing World. Developing countries see that climate change is a major concern in developed countries. Developing countries want greater access to capital flows from these countries. Embracing the buzzwords “climate finance” helps these risky nations tap into international finance flows that they might not have accessed at a low interest rate during earlier decades.
Some of these LDCs do want to implement low carbon projects and climate change adaptation projects and these capital intensive projects will be cheaper to implement if developed nations subsidize interest rates. At the same time, LDCs want to borrow at a lower overall interest rate to fund all of their projects and ambitious politicians want to launch more projects in order to create construction jobs and grateful local voters and supporters.
So, the same issue I sketched above for beer and rice consumption and the rice subsidy will arise here. How will the World Bank calculate the counter-factual of the pace of climate investment projects with and without the interest rate subsidy? It is true that if developing countries were doing none of these green projects before the subsidy then there are fewer concerns about “crowding out”.
What is to be done? Ideally each nation would generate its own credible McKinsey Curve . Source for this graph
Such a curve can be used like a “batting order” in Baseball to show what is the marginal next best project that can lower greenhouse gas emissions per $ spent. A subsidy could be offered for the marginal project to nudge the host government to implement that project based on the Social Cost of Carbon. Five years later a verification could take place to see if the project was actually built and yielding the ex-ante expected rate of return. Those nations whose carbon mitigation projects can be ex-post verified would receive more favorable subsidies going forward. This dynamic game create the right incentives to accelerate decarbonization.