The 2020 Climate Challenge for Development Banks: Aligning with the Paris Agreement
Public development banks have a major role to play in the fight against climate change, as highlighted again recently by Mark Carney, now UK’s Finance Adviser for COP26. For this community, action in 2020 will coalesce around key events such as the IMF-World Bank meetings, a new Summit of Development Banks slated for November and obviously the crucial COP26 in Glasgow. Ian Cochran and Alice Pauthier explain in this blogpost the principal technical and political challenges those finance institutions will need to overcome in aligning with the Paris Agreement objectives.
Public development banks such as the Caisse des Dépôts and Agence Française de Développement in France, KfW in Germany, the African Development Bank, the European Investment Bank and the World Bank are actively involved in financing the development – and often the ‘transformation’ – of national economies in line with government policy objectives. They have an important role to play in the fight against climate change and many of them have formally recognized this role by committing to “align” their activities with the long-term climate objectives of the Paris Agreement.
Since 2017, development banks have been developing common principles on alignment that will be critical for their own alignment, but also of use for the entire financial sector. However, to date there is no consensus on what it means to align with the Paris Agreement objectives. To help establish a common language to talk about the challenges related to alignment, we recently published a study to support the development of such principles: the I4CE “alignment bullseye” provides a common guide for all financial actors that highlights the main challenges for each type of institution and in particular for public development banks.
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Doing no harm
The first challenge of alignment is to “do no harm”. Over the last few decades, public development banks have focused their climate efforts on financing projects that reduce greenhouse gas emissions, such as the production of renewable energy and energy efficiency. Financing such development projects with climate co-benefits is important, but it is also essential not to finance, for example, the construction of a new coal-fired power plant in parallel. Therefore, in order to “align”, institutions first have to do no harm across all of their business lines.
The problem is that it is not always easy to determine what is harmful – or helpful – for the climate. What about a new gas-fired power plant, for example? It emits less than a coal-fired power plant, but unless retired early at a potential loss will still be there in several decades when most countries will have to be carbon neutral. Energy efficiency investments often pose similar questions.
This exemplifies that when identifying what is harmful or helpful, it is essential to take the long-term into account in order to avoid technological lock-in, as well as national circumstances and choices. For example, if a gas-fired power plant in France would be in contradiction with the country’s 2050 objectives, would it necessarily be the case in a country with limited energy access that today relies on coal? How can this be determined when many countries have not developed long-term decarbonation strategies yet, or at least not ambitious enough? Not to mention the social stakes and the trade-offs that sometimes have to be made between the different Sustainable Development Objectives.
In short, determining what is aligned or non-aligned with climate objectives is not an easy task, and development banks may have different interpretations at times of the same context. To help them, it is essential that countries take seriously the exercise of defining their long-term climate strategies, and that public banks support these exercises in a cooperative and coordinated fashion.
Seeking “transformational” impact
An aligned public development bank should “do no harm”, therefore financing wind turbines and coal-fired power plants simultaneously will almost never make sense. However, development banks will also need to make sure that they are getting the most impact out of the precious (and limited) public resources they are entrusted with. Thus, what is the point of a development bank financing an additional wind turbine when other financial actors could do it just as well? It is essential that development banks focus on the impact when asking how to maximize their use of public funds? How can it best contribute to the transformation of economies?
This search for “transformational” impact is, in our view, one of the main challenges of alignment with the Paris Agreement. A challenge that should not be underestimated given that as a result of the structure of climate goals – ie the famous 100 billion commitment – development banks are more used to thinking in terms of volume of financing than impact on climate.
What does this shift to focus on ‘impact’ mean in practice? It implies not just scaling up the volume of finance, but in some cases also rethinking the tools to use – and how to use them. To support the development of renewable energy, a public bank can finance pilot projects of new technologies that are not yet mature or support the planning and construction of an electricity grid incorporating an increasing proportion of renewable energy. It can also provide technical and financial support to national ministries of energy and finance, as part of a public policy loan, to help them establish a public support mechanism for renewable energy. And although sometimes, in some cases they could even support the transition of key enterprises in the carbon sectors of the economy by using their leverage as shareholders and financers to actively push them to adopt and implement short-term decarbonization strategies.
These examples highlight another challenge that we believe is important: the scope of the alignment must be broad, it must cover all the operations of a development bank and, in turn, be ingrained systematically into their relationships with counterparties. It should not just concern project financing, but also public policy loans, intermediated financing, long-term dialogue and support for counterparties. It must cover all financing tools, both loans and guarantees.
The mandate of public development banks
There are many challenges to alignment: First, financing projects with climate co-benefits, but also do no harm and seek the most transformational impact possible. Second, doing this across all operations and all types of counterparties, while taking into account national and long-term contexts. And the list goes on… And we have only focused here on the reduction of greenhouse gas emissions – development banks cannot forget that adaptation to climate change is an essential part of alignment as well!
Many of these challenges are of a technical and methodological nature, and there are fortunately forums for dialogue and exchanges where financial institutions can share their questions with each other. This is notably the case of the Climate Action in Financial Institutions Initiative who actively worked on the topic of Paris Alignment in 2019, for which I4CE is the secretariat.
While these technical discussions are progressing and rightly often have center stage, it is important not to downplay the importance of the more ‘political’ dimension of alignment. Stopping the financing of fossil fuels and supporting one development model over another are not decisions made in isolation by operational teams and managers of public development banks. They are also, and above all, the responsibility of governments, which define the mandates of these institutions. For example, if we want to ensure that the activities of the European Investment Bank are aligned, European governments must ensure that this is an explicit part of its direct and indirect mandates – and that decisions made by country representatives on the institutions board are consistent with this goal.
2020 will be an important year for climate change as it starts a critical decade. Putting on the table all of the enabling conditions for the alignment of public financial institutions – whether technical or political – will be essential. The Summit of Development Banks to be held in November 2020 could be a major milestone in that respect, on the road to COP26 in Glasgow.