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MDBs are committed to aligning financial flows with the Paris Agreement. You are not there yet

Image by Milos Golubovic via flickr (CC BY-NC-ND 2.0)

Two years after the 2015 Paris Agreement, the world’s multilateral development banks (MDBs) have committed to aligning their financial flows with the goals of the pioneering climate pact.

Now, four years later, it is clear that the MDBs as a group are still a long way from realizing their commitment to their portfolios. While the MDBs have focused on aligning direct investment with the Paris goals, these efforts are neither ambitious nor complete. They paid less attention to whether their indirect investments support the climate goals. And policy-based loans – a popular instrument in times of crisis – also remain a blind spot.

When we updated previous research on the Paris alignment pledge by the MDBs, we found that these banks need to meet their commitments by 2023-2024 in order to meet their commitments. Individual banks are making progress, but their efforts are not shared across the group. Effective governance by the MDBs under an ambitious common framework is key to meeting their climate commitments.

During COP26, these are the main areas they need to address to show that they are at the forefront of efforts to align with the Paris Agreement.

  • The guidelines for the exclusion of fossil fuels must be expanded and standardized in all institutions. Standard fossil fuel exclusion practices can reinforce the market signal that the future of fossil fuels is limited. Since 2018, the European Investment Bank and the Inter-American Development Bank have formalized new criteria to exclude the financing of coal, oil and gas projects. Conversely, the African Development Bank, the Asian Infrastructure Investment Bank, the Asian Development Bank and the World Bank Group have left emission-intensive projects in their project pipeline because they lack formal criteria for excluding fossil fuels. As a positive sign, the African Development Bank and the Asian Development Bank are expected to formally exclude coal in their updated energy policies, and the latter is planning an energy transition mechanism to introduce public-private partnerships to buy and decommission coal-fired power plants.
  • MDBs need to standardize how they count and price emissions. The MDBs still lack a uniform approach for accounting for greenhouse gases (GHG) and the application of Scope 3 emissions. Since 2018, the European Bank for Reconstruction and Development and the World Bank Group have expanded their CO2 emission limits to include emissions when making more investments. The African Development Bank has started to test greenhouse gas accounting at project level, but has not set any emissions targets; No other bank has updated its greenhouse gas emissions accounting policy since 2018. All MDBs should target the EBRD, EIB and IDB for public reporting on portfolio-wide issues. In setting a shadow carbon price for their activities, many of the MDBs have closely followed the recommendation of the High Level Commission on Carbon Prices (HLCCP), while others have not applied shadow carbon prices consistently across projects. The European Investment Bank recently decided not to use a lower bound on the price of carbon, which increases the total cost of carbon for all projects and makes it less likely that the bank will fund high-emission projects.
  • With developed nations’ pledge to collectively mobilize $ 100 billion in annual climate finance is likely to be about $ 20 billion short, the MDBs will require reforms to fill this gap. Almost every bank has made remarkable strides in raising climate finance targets since 2018, particularly beyond 2020. Still, MDB climate finance for developing countries defined by the UNFCCC has declined by almost 5% in 2020 compared to 2019. Many banks claim that recently climate finance goals are reaching their limits and a radical change is needed to meet the demand for transformation investments needed to achieve net zero emissions by mid-century and to lead the way in financing adaptation and resilience.

Not all instruments aimed at Paris

The MDBs also need to take a more holistic approach to targeting Paris, including assessing climate risks before deciding on operations. While they have made progress on direct investment, other instruments remain uncovered. At the International Finance Corporation of the World Bank Group, for example, many investments are channeled into indirect investments through financial intermediaries. And the policy-based funding in the MDBs they use has been the bulk of the support for countries to deal with the COVID-19 crisis.

  • Support for capacity building for the Paris alignment of financial intermediaries and counterparties. Many MDBs, especially in their private sector windows, place significant portions of their total investment through local financial institutions. This enables them to indirectly finance smaller customers or projects and help strengthen the domestic financial markets. Typically, however, MDBs do not always know exactly which sub-projects will benefit from their funding when an investment is agreed with a financial intermediary (FI). This requires the FI customer to be Paris-aligned in turn in order for the MDB to claim that the finances passed through the FI are Paris-aligned. We propose a risk-based, tiered approach to indirect investment alignment that recognizes that FIs have different capacities to implement alignment and encourages the MDBs to assist them in this regard. In addition, the approach should include a process for disclosing climate risks for all projects within the banks’ portfolio. The MDBs will present their common methodology for targeting indirect funding at COP26. The EIB will also provide guidance on counterparty alignment that goes beyond FI and also includes corporations. Other MDSs should follow this broader view of the Paris targeting due diligence.
  • Make policy-based finance an instrument for climate protection. Policy-based funding works by closing the budget deficit loophole in return for recipient governments implementing pre-agreed political and institutional reforms, or “policies”. These reforms can have detrimental effects on a country’s ability to meet its climate goals. For example, it has been shown that the WBG creates incentives for new investments in fossil fuels in some projects by supporting laws that are supported by policy-based measures. At the same time, guidelines and regulations that align government activities with climate goals and increase market incentives for green technologies and practices are crucial to putting economies on low-emission, climate-resilient paths. Policy-based funding can provide an additional incentive for such reforms, as demonstrated by IDB support for Costa Rica’s decarbonization plan. For alignment with Paris, banks that provide policy-based finance must ensure that policies do not harm climate targets and, wherever possible, identify opportunities for climate-friendly reforms.

Climate leadership in a difficult moment

Development banks are the link between the public and private sectors as well as industrial and developing countries. With their ability to provide licensed finance (especially for riskier long-term investments) along with technical and policy expertise, MDBs should lead, not lag behind, in the transition to a low carbon and climate resilient transition.

Against the background of this transformative investment need, however, the immediate challenge arises from the rise in debt caused by COVID. Aligning all political frameworks, strategies and financial flows with the Paris Agreement is already a major challenge; the pandemic has made this even more difficult. The MDBs are major creditors in developing countries. (For example, the WBG and other multilateral creditors make up 41% of all African debt servicing). After the pandemic created budget imbalances through high spending and low income, financial resources have shrunk. Developing countries may have no choice but to put climate action on the table – which the MDBs (and the IMF) must ensure that it doesn’t happen. The MDBs can anticipate this possibility by actively participating in debt relief initiatives that protect the climate.

MDBs aren’t quite their masters, however. The shareholders’ governments vote on their policies. These parties need to provide guidance on how to move the Parisian alignment from the abstract level of policies and strategies into the operation and essence of the MDBs. Ultimately, the mandate to meet these challenges must come from the shareholders.

Recent developments suggest that if governments are involved, they may be up to the task. While progress across MDBs has been inconsistent, the G20 countries have themselves taken the lead in overcoming fossil fuel financing in recent months. The G7 agreed earlier this year to end international support for coal power. The United States has issued voting guidelines to more broadly limit MDB investments in fossil fuels. China has committed to stop building new coal-fired power plants abroad. The Powering Past Coal Alliance – a coalition of governments, companies and organizations that is committed to phasing out unabated coal-based power generation – includes in particular 15 developing countries among its 41 national government members.

Progress in aligning all financial flows in Paris needs to be swift, given the urgency to increase support for increased climate action and the timelines that the MDBs themselves have set. Your work is not over yet.

This article was originally published on WRI Insights.

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