Climate Finance with Limited Commitment and Renegotiation: A Dynamic Contract Approach

Taking climate funds (e.g., the Green Climate Fund) as the main financial mechanism for providing funding to developing countries, this paper examines a long-term climate funding relationship between two parties—the rich country and the poor country. Conflicts between the rich and poor countries arise when determining (1) the size of climate funding that the rich country contributes to the poor country and (2) the funding allocation between climate adaptation and mitigation projects in the poor country. In addition, the rich country cannot be forced to commit contractual contributions to the poor country, and in each period, there is a probability that the countries can renegotiate the contract. This paper derives two main dynamic comparative–static results: (1) climate funds converge to the first-best in the long run, both in the size of climate funding in adaptation and mitigation projects, if and only if climate damage becomes sufficiently severe; (2) fewer renegotiations between the rich and poor countries make climate funding contracts more efficient, remedying inequality between the poor and rich countries. These results highlight how increasing climate damages and reducing the frequency of renegotiation can push climate funds closer to a first-best allocation, suggesting design principles for climate funding mechanisms like the Green Climate Fund.