Audio Finance - 01/June/2020

Development banks struggle with fossil fuel lock-in

The world’s development banks are funnelling ever-greater volumes of finance into clean energy — but the challenge of shifting entire economies away from climate-wrecking activity and towards actions that align investment goals with those of the Paris Agreement requires a more holistic approach

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This article comes from the spring 2020 edition of the FORESIGHT Climate & Energy magazine, which was largely written before, or at the beginning of, the Covid-19 pandemic. 

Development banks directed $50 billion of funding to fossil fuel projects in the five years to the end of 2018, almost as much as the $58 billion they invested in clean energy

 

COULD DO BETTER Banks charged with investing public money in economic development are increasingly concerned about the risk climate change poses to financial assets, but few are redirecting investment to achieving the goals of the Paris Agreement. Too many decisions are based on outdated knowledge about alternatives to fossil fuel projects

LEADERSHIP NEEDED Heads of development banks should join politicians and show leadership in diverting money from fossil fuels to green energy and stimulating energy savings 

KEY QUOTE Leading development banks are looking at both green and brown investment, and are looking at climate-related financial risk

 

The world’s leading development banks are becoming climate finance powerhouses. In 2018, they directed $43 billion to projects or programmes in developing countries with the purpose of mitigating climate change or adapting to its consequences. Their investments attracted an additional $68 billion in co-financing. At the UN Secretary General’s summit in New York in September 2019, nine of the leading multilateral development banks (MDBs) pledged to increase their annual climate change investments to $65 billion by 2025, 50% above current levels.

Many are continuing to support fossil fuel projects, however. Development banks directed $50 billion of funding to fossil fuel projects in the five years to the end of 2018, almost as much as the $58 billion they invested in clean energy, show figures from Oil Change International, a US-headquartered non-profit organisation. Few of the banks can claim their portfolios are compatible with the Paris Agreement goal of holding global warming to no more than 2°C above pre-industrial levels, say campaigners.

“In general, development banks have got much better at climate change over the last ten years,” says Matthew Huxham, a London-based energy finance specialist at the Climate Policy Initiative, a global think-tank. In particular, they have made progress in using their funding to reduce the risk of clean energy projects and attract other sources of finance as co investors, he adds. “This, however, only addresses how to get more money into green — it does not address what happens to existing brown investment.”

The problem lies with their own portfolios and within client countries, continues Huxham, though signs of an awakening are apparent. “The leading development banks are now looking at both the green and the brown and are looking at climate-related financial risk,” he says.

 

 

POTENTIAL EXPOSURE

But for many development banks, the effort has yet to extend much further than increasing their allocations to supporting renewable energy — meaning they are potentially exposing themselves and their client countries to significant climate risk. Many are justifying continued investment in fossil fuel capacity in developing countries based on perceived need — often based on outdated assumptions about the cost and capability of modern clean energy alternatives.

“What we are seeing very little of is rigorous interrogation by development banks of the actual need for fossil fuels, at the project level, in terms of energy system requirements, and in terms of the financial risks of investments in conventional fossil projects,” says Iskander Erzini Vernoit, a London-based researcher at E3G, a climate change think tank.

This lack of thought is of particular concern given the important role development banks play in helping client countries develop their energy sectors. “These institutions have deep sectoral expertise,” he says. They are often closely involved with helping developing countries plan their energy systems. “But in terms of things like technical assistance … to contribute to energy sector strategies, plans and roadmaps for countries, you are seeing wholesale lock-in to fossil fuel technologies with little scrutiny or oversight,” Erzini Vernoit says.

Given the long lifetimes of many energy sector investments, the risk is that these assets become stranded as renewable energy becomes cheaper, with the costs borne by client country, electricity customers and taxpayers, Erzini Vernoit adds.

 

UNDERWHELMED IN MADRID

Development banks are certainly cognisant of their role in addressing climate change. The World Bank has long argued that climate impacts threaten to reverse economic and social progress in its client countries. At the 2018 climate talks in Katowice, Poland, nine leading MDBs promised to unveil their “joint Paris alignment approach and individual MDB progress towards alignment” at COP25, held in Madrid, Spain in December 2019.

The Madrid announcement, however, underwhelmed some observers. “We had expected more ambition by this point,” says Lauren Sidner, a research associate in the World Resources Institute’s Finance Center, in Washington DC. The proposals made so far allow lots of leeway for interpretation, she says. They give significant time for implementation and only cover banks’ direct lending, initially excluding as much as 50% of some MDB’s funding that is provided through financial institution intermediaries or as policy-based loans, explains Sidner. Policy loans refers to general funding to governments in exchange for policy reforms. “They have not committed to full implementation [including all financing] until 2023-24, which is a much more drawn-out process than we expected based on the announcement in Katowice,” she adds.

The Paris alignment initiative is, however, comprehensive. It is based on six building blocks: aligning operations with client countries’ mitigation goals; managing physical climate risk; increasing climate finance to support clients’ low-carbon transition; supporting clients’ policy development; reporting on MDBs’ own Paris-related activities; and ensuring their own internal activities are in line with the agreement’s objectives.

“Many banks are still struggling to understand what Paris alignment means,” says Sophie Bartosch, policy advisor at Germanwatch, a Berlin-based NGO. “At the moment, no [development] bank has a holistic approach to ensure Paris alignment of all new commitments, let alone their entire existing portfolio.” Bartosch adds: “Development banks are not moving at the same pace and some are backtracking — especially those where the US is a large shareholder. The US has been blocking ambitious new climate strategies.” Bank insiders, particularly at the World Bank and the Inter-American Development Bank, tell activists that US influence is restricting their work on climate change.

The issues are not only political, some argue. Nancy Saich, chief climate change expert at the European Investment Bank (EIB), one of the nine MDBs, says drawing up guidelines that can be applied across different project types, sectors and regions by very different institutions is highly technical and complex. “Not that we were naïve, but when you start to put things down on paper, it becomes a lot more complicated than we perhaps thought it would be.”

This need for consensus could hold back collective progress, some fear. “An MDB-led process is likely to be limited in terms of what it can deliver,” says Erzini Venoit at E3G. Other countries with major fossil-reliant sectors share the interest of the US in stalling climate action, he adds.

 

EUROPE LEADS THE FIELD

European development banks are making the running. The first to explicitly commit to Paris alignment was Agence France de Developpement (AFD), in 2012. It aims to direct 50% of its investments to climate finance. Following the Paris talks, its new climate strategy, drawn up in 2016 states clearly that all financing is to be screened for its compatibility with AFD’s climate future, says Damien Navizet, head of the agency’s climate division.

The screening involves ranking all investments against four qualitative criteria, including whether a project is aligned with the country’s nationally determined contribution (NDC) to emissions reduction, whether it risks locking-in emissions over the long-term and whether it has any demonstration benefit. “It is firstly about avoiding transition and physical risks over the long term, but it is also about the transformational impacts of projects,” he says.

The new policy has seen AFD turn away some mining projects and become stricter with its assessment of natural gas investments, but Navizet says the immediate impact on AFD’s activities is minimal. “We already had a ten-year track-record of taking climate into account in our projects — so it was less painful than it could have been,” he states.

Following the trail blazed by AFD is the EIB – the world’s largest MDB by assets and long at the cutting edge of climate finance. It has won plaudits for the climate strategy and energy lending policy it unveiled in November 2019. EIB announced a target of “unlocking €1 trillion of climate action and environmental sustainability investment” in the decade to 2030, ending financing for all fossil fuel energy projects by the end of 2021 and, from the end of 2020, aligning all financing with the goals of the Paris Agreement.

The plan has two elements. The first is that it will stop supporting projects that are not compatible with a low-carbon pathway, says Saich. Crucially, it will no longer support unabated natural gas projects from the end of 2021. The other is to “proactively set out to invest in the transition agenda,” she adds. The EIB’s sector teams are working on exactly what that means, industry by industry, but the bank is likely to considerably increase its investments in research and development and innovation around climate, she states.

But, and perhaps more importantly, says Saich, the EIB’s new approach involves working more closely with clients. Paris alignment requires understanding how a target project fits within the client’s decarbonisation and climate resilience plans, says Saich. “It is the client, not the EIB, ultimately, that’s going to decarbonise and adapt to climate impacts.”

 

 

SUPPORT FOR THE VULNERABLE

The new EIB approach also stresses the need to support vulnerable workers and communities as economies transition away from carbon-intensive activities. The bank says it will introduce measures: “To ensure EIB financing contribute to a just transition for those regions or countries more affected so that no-one is left behind.”

The EIB is also assessing the climate risk it may have taken on in its existing portfolio of some €600 billion of investments, although it remains undecided on what action to take to mitigate any exposure. “We have not worked through all the options yet … although, my view is that I don’t see a multilateral development bank going back and asking clients to repay the loan,” says Saich.

 

FINITE BUDGETS

Perhaps one of the most ambitious approaches is under development by FMO, the Dutch private sector development bank. While much of its investment had been directed towards renewables and energy efficiency, the Paris Agreement “changes the game”, says Mikkel Kallesoe, its senior impact adviser. “It is about a finite carbon budget for the world and therefore we need to have a much better understanding of the total emissions we are financing through our investments.”

Fundamentally, Kallesoe draws a distinction between how the MDBs are approaching Paris alignment and the tack taken by some bilateral European development banks such as his. The MDBs are “delivering in accordance with country NDCs”, the Nationally Determined Contributions to global emissions reduction, he says. In this way they are being true to the process of the Paris Agreement. “The problem is, the current NDCs get us nowhere near to 1.5°C,” he states. FMO has targeted the more ambitious temperature goal. “As a responsible investor, we have an obligation to support the least harmful pathway,” says Kallesoe. Keeping below 1.5°C is still achievable, but requires transformational change as well as investing into negative emissions, he adds.

FMO has taken a portfolio-wide approach, looking at its investments on the basis of “absolute emissions accounting”, to build a picture of its overall emissions over time, says Kallesoe. The bank has undertaken considerable technical work to calculate emissions from the activities it finances and how they fit with a 1.5°C emissions trajectory. It has recently published two papers on the subject, one on setting a 1.5°C pathway and the other in its approach to GHG accounting for financed emissions. While its portfolio is in line with a Paris emissions trajectory, reaching net-zero by 2050 will require some re-orientation, says Kallesoe.

FMO has dismissed two extreme responses, of divesting from all carbon-emitting sectors or alternatively buying carbon credits to offset its portfolio emissions. Instead, it has resolved to increase the proportion of its investments that qualify for its Green Label. These are investments which avoid and reduce greenhouse gas emissions, support adaptation and tend to be low emitting, and increase allocations towards investment that reduce concentrations of atmospheric carbon dioxide. These solutions can include forestry, low-carbon agriculture and other nature-based climate initiatives.

FMO does not count investments that avoid emissions (such as in renewable energy companies) as negative emissions. As a result, it will always have emissions in its portfolio, admits Kallesoe. “The only way we can get to net-zero by 2050 … is to also invest in negative or sequestered emissions.”

 

 

CLEAR STEER

Whether the effort to align lending by development banks with the goals of the Paris Agreement will be successful depends on extensive, highly technical work, say observers. But given legitimate disagreement about what constitutes such alignment, success will depend on a clear steer from the very top of these organisations, argues Sidner at the WRI. Leadership from member countries that are borrowing from the banks, calling for greener, more sustainable finance would also be important, she adds.

While it is relatively straightforward to draw up limited lists of activities that are clearly climate friendly or unfriendly, there is considerable scope for interpretation across a whole range of technologies and project types. “There is a lot of room for development banks to come to different conclusions on the difficult questions,” she says. “For these commitments to become real, we need board-level policy … to say they will not approve mis-aligned projects.”

Sidner warns: “Without leadership from the top, mis-aligned projects will continue to come forward,” she says. “This is where political leadership makes a big difference … it goes a long way towards making these processes meaningful.”

 

TEXT Mark Nicholls

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