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Climate funds and DFIs under the microscope?


The role of multilateral and bilateral banks and climate funds in deploying catalytic finance for Paris-related investment has always been seen as critical.  To date, the way they operate has remained largely unquestioned.

This month, however, we have seen the publication of major reports from three of the most high-profile think-tanks in the climate finance arena –  ODI, WRI and IIED – all focussed on this topic and all calling for quite significant changes in behaviour.

The key points from each report are summarised (in a mixture of my words and theirs) in the boxes below.

ODI: Six development finance proposals to expand climate investment
  1. Increase multilateral development bank (MDB) loan to capital ratios to at least 5-7 times equity
  2. Expand development finance institution (DFI) use of guarantees by accounting less conservatively for expected losses
  3. DFIs to catalyse accelerated deployment and market development of technologically proven, post R&D clean energy solutions in developing economies, acting as “venture capitalists” for these technologies in these markets
  4. Strengthen MDB support of national financial intermediaries via targeted assistance at subsidised rates to support climate-friendly investments
  5. Create a new global Green Cities Development Bank, with access to international capital markets from an investment grade credit rating
  6. Create a new mechanism for reimbursing national debt repayments by low-income countries in return for achieving low-carbon investment programmes

WRI: The Future of the Funds

Climate funds should:

  1. Deploy their resources catalytically to mobilise larger flows of funding
  2. Channel finance to support nationally determined priorities and strengthen national capacities to plan, implement and monitor climate action
  3. Pursue greater efficiency in minimising transaction costs, speeding up project delivery, and providing access to money
  4. Support equitable allocation of funding to reach developing countries with the greatest need, for the range of climate actions that will be necessary
  5. Increase accountability to ensure that activities fulfil mandates and comply with operational policies

IIED: Delivering real change – Getting international climate finance to the local level 
  1. Change the metrics of success: for example, counting numbers of people with access to energy rather than MW installed would prioritise local distributed energy
  2. Widen the net and avoid using ‘business as usual’ intermediaries such as MDBs, which are not set up to deliver smaller projects
  3. Use the innovative financial instruments that are available to increase the level of risk taken by MDBs and DFIs
  4. Provide more support (and allow more time) to build local capacity to generate climate finance flows
  5. Avoid co-financing conditions (for example cash contributions) that discriminate against local level finance: count collective community action as co-financing
  6. Create agreed international goals for levels of local funding and monitor these for achievement

For more ‘colour’ on the IIED’s recommendations, see our discussion with Clare Shakya

Note: For the purposes of the commentary that follows, I will merge MDBs and DFIs under the single heading of “DFIs” and, by “climate finance” I mean finance from sources such as DFIs and multilateral and bilateral funds

Behaviour change needed more than vast extra funding?

There are two immediately striking things about this set of 17 suggestions.

The first is that, with the exception of ODI’s two final suggestions (a new Green Cities Bank and a low-income country debt reimbursement mechanism), none involves significant innovation.

The second is that the suggestions put forward don’t necessarily involve huge amounts of new official climate finance either.  Instead, they focus on levering this finance to a far greater extent, channelling its flows much more efficiently to where is it needed (rather than where institutional agendas and risk appetites currently send it), and being more transparent about (a) what is going where and (b) how effectively it is being used.

What the think-tank conclusions do all call for are fairly major changes in the way that climate finance providers presently do business.  We can perhaps see this more clearly by grouping the suggestions thematically, under three headings:

Risk:  The risk appetite of DFIs, both in terms of capital ratios and counterparties

Positioning:  The roles which DFIs see themselves playing in, for example, creating new markets, and helping to crowd in private finance

Accountability: The transparency and efficiency of DFI operations

This produces the following “clusters”

Risk Positioning Accountability
ODI 1,2: Increase capital ratios and use of guarantees 3,4:  DFOs act as “venture capital” for proven technologies in emerging economies, and supporting local market development with subsidies
WRI 1,4:  Deploy resources catalytically and to support countries in greatest need 2: Channel finance to nationally determined priorities 3,5:  Greater efficiency & speed of delivery, better monitoring of activities vs mandates
IIED 2,3,5:  Widen the net of intermediaries, including local actors, and use innovative financial instruments to increase level of risk taken 1, 4:  Change the metrics of success, channel more support to national capacity building 6: Agree global goals for local funding

In terms of the leverage of climate finance, while the call is for greater risk-taking by climate finance providers, the ratios mentioned are hardly reckless.  For example, in making its call for an increase in MDB loan ratios to 5-7 times equity capital, ODI notes that a typical commercial bank operates at a ratio of 10x capital.  In our recent green bonds note, we reported that the European Investment Bank has recently had its ratio lifted to 15x.  This higher EIB ratio actually seems to accord better with the role of a risk-taking development bank, typically backed by AAA sovereign guarantees, compared to a commercial bank.

Capital use appears highly inefficient

As things stand, ODI notes that ratios go as low as 4x equity for the World Bank, and only 2x for the EBRD.  Assuming they are correct, those are astonishing findings, which represent a wildly inefficient use of public capital resources.

In terms of the “catalytic” use of DFI capital – for example, to transfer proven renewables technologies into emerging economies as called for by ODI – this accords very closely with a notion I floated in a report on the INDCs published at the Paris COP, Climate Finance after COP21 – Pathways to Success.  This was the concept of a ‘hierarchy’ of green/climate finance, illustrated in the graphic reproduced below.

In the top layer of this hierarchy are projects and technological advances in developed countries which will almost exclusively be financed by private capital, via commercial bank lending, bonds (green or ‘vanilla’) or by companies on their own balance sheets.  Classic examples would be more efficient vehicles and green buildings.

At the bottom are projects which have little or no commercial potential and will therefore rely on donor or other concessional funding.  This is the only layer where ‘unlevered’ public finance should be employed, and even at this level there can be far more imagination deployed in terms of what counts as leverage – see for example IIED’s call for local community in-kind inputs to be treated as co-financing.

All public climate finance deployed in hybrid structures should be more risk bearing than private finance in those structures

In between these two layers is a set of projects – under both mitigation and adaptation headings – which will require a hybrid approach, with private funding de-risked in a number of ways by public funding, whether this is by the provision of guarantees, first loss tranches* in structured finance vehicles* or currency hedging*.  This is the layer where any and all public climate finance must be significantly risk bearing, that is, crowding in capital with a lower risk capability, not replacing it.  This is where the calls by all three think-tank reports for changes in risk appetite are relevant and need to be addressed by DFIs with substantive changes to both their risk models and behaviour.

Under the heading of positioning, we would add in one more role for DFIs:  to be recyclers of capital.  It’s hard to see why DFIs don’t do a better job of selling on the assets they’ve helped to create, to pension funds and other long-term investors where the risk profile is appropriate.  This would allow the DFI’s to put their assets to work again, in bringing more development projects to fruition.

DFI shareholders are the masters of change

How, though, will the changes the think-tanks are calling for be effected?  The DFI model is decades old, behaviours are very deeply ingrained, and they are bolstered by the way that staff are incentivised – which primarily rewards the constant accumulation of low-risk assets that grow the balance sheets of their institutions and avoid their senior officers having to answer awkward questions about losses.

Step forward into the spotlight some hitherto fairly obscure characters in our drama, the shareholders in the DFIs and the climate finance funds.  Typically these are governments, and typically they will be represented by civil servants.  If these representatives have any finance expertise at all, it will typically be in development and not commercial finance.  And the politicians they report to will very likely have no financial expertise whatever.

We might, therefore, add one more recommendation to those of our three think-tanks:  financial education among the shareholders of the DFIs and climate funds.  Without a radical overhaul in thinking at this level, there will not be the capability to re-purpose DFI mission-positioning and risk models, nor to drive through behavioural change by means of an overhaul of incentivisation structures.

We need to be in a position where the awkward questions shareholders are putting are not “Why are there losses”, but rather “Why aren’t there more losses?” And where pats on the back come for the quantum of assets recycled into private hands rather than for bulking up the balance sheet.

Perhaps some kind climate fund will set up a grant programme for this particular variety of capacity building …

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