The development finance institutions (DFIs), including the multilateral development banks (MDBs) and national development banks (NDBs), play an important role in supporting socioeconomic development and widening access to finance. Increasingly they focus on enabling sustainable development and meeting the SDGs.
Public financial institution investments total USD2.2tn annually. They offer cheaper financing and wider technical assistance to governments and the private sector. They have unique abilities to support the transition to a 1.5°C world.
It is important to ensure that the capital channelled by international development banks to finance the green transition reaches developing countries. As these countries are starting from a lower development status and have huge modernisation needs, every dollar invested there will lead to far greater emission reductions than the same dollar invested in developed countries.
As stated before, the climate transition will require the reorientation of both public and private finance flows. DFIs can play a greater role in mobilising private capital. This could require a change of model from originate and hold to originate and sell. This would free up balance sheet space to enable greater green lending, using instruments such as securitisation, similar to many commercial banks’ business models.
Guarantees and credit enhancement are a key tool for DFIs to maximise their balance sheets and mobilise private finance. DFIs can provide first loss guarantees, subordinated debt lending, or non-honouring of financial obligations guarantees. Guarantees provide investors with greater certainty of returns, thereby enabling private investment into projects that would otherwise be viewed as too risky. Many DFIs provide specific green guarantee facilities. For example, Asian Development Bank (ADB)’s Pacific Renewable Energy Programme provides partial risk guarantees and letters of credit facility to enable private sector investment in Pacific Island renewable power projects. To increase their effectiveness, guarantee instruments require standardisation.
DFIs can offer loan syndication, this involves providing co-financing with a commercial bank or other lender. The commercial bank can share the DFI’s preferred creditor status, increasing its risk tolerance. Loan syndication allows a commercial bank to provide financing at a lower rate – ensuring demand, and enabling structuring to best suit demand and achieve lower financing.
Support domestic green finance
DFIs were important pioneers in the early green bond market, with the EIB and World Bank issuing the first green bonds in 2007. Green bond issuance enables development banks to fund green projects, and finance investment in green bonds from other issuers. Issuing green bonds in local markets can also help kickstart local markets, similarly to sovereign issuance. Development banks can fulfil this role in jurisdictions where the sovereign or municipalities do not have the capacity for issuance.
Development banks can also provide anchor investment in local green bond issuance. This can enhance the perceived credibility of the issuer and build investor confidence.
DFIs also play a key role in providing capacity building and technical assistance to governments for green bond issuance, see Finance. Technical assistance can include project pipeline development, framework development and securing SPO providers and arrangers. They can also help to align issuance with national transition pathways and climate goals. However, capacity building is not limited to green bond issuance. MDBs can support implementation of sustainable finance policies across the government and within many institutions.
DFIs can also enable securitisation, acting as sponsors of or investors in green aggregation facilities, (warehouses/conduit entities). These can both package assets and provide standards around contracts and loans accepted for packaging. Such aggregation facilities can play an important role in driving standardization of contracts and credibility of green loans by setting out minimum requirements for green securitization.
Align activities with a 1.5°C pathway
To ensure they fund truly sustainable development and align their activities with a 1.5°C pathway, DFIs can also become green or climate banks. National Green Banks can both meet the specific financing requirements of the net zero transition and send a clear signal of national intent to align investment with net zero. While some countries have established separate green banks, national development banks (NDBs) can be transformed into green banks.
The European Investment Bank’s Climate Bank Roadmap 2021-2025 aligns the bank with the EU’s climate commitments, establishing it as Europe’s climate bank. The Roadmap established two objectives, to dedicate 50% of its overall lending activity to climate action and environmental sustainability by 2025 (achieved in 2021), and to ensure “all financing activities are aligned to the goals and principles of the Paris Agreement by the end of 2020”. National development banks can align with their countries’ NDCs, and establish a roadmap to decarbonise lending and scale up sustainable financing.
Increasingly channelling funding to green
To align their activities with 1.5°C, DFIs’ funding can be guided by either a national Taxonomy, or the MDBs and IDFC’s joint Common Principles for Climate Mitigation Finance Tracking. By dedicating an increasing proportion of funding to green, and setting clear deadlines for ending financing of fossil fuels and other damaging practices, the DFIs can transition to green, without causing economic shocks by suddenly withdrawing funding for certain activities. For example, the EIB’s Climate Bank Roadmap 2021-2025 included the decision to dedicate 50% of its funding to environmental and sustainability activities, and ensure all activities do no significant harm to the Paris Agreement goals. Its list of eligible activities is aligned with the 1st Delegated Act of the EU Taxonomy.
In order to increase their green investments, MDBs could change their risk appetite. If they were to relax capital requirements and forgo their AAA credit ratings, this could significantly increase their lending capacity. One calculation suggests the six biggest lenders could have lent an additional $1.3tn by accepting a one-notch downgrade in their credit ratings to AA+ during the pandemic.
Disclosing against the TCFD framework ensures transparency within DFIs, increases awareness of their activities and can encourage disclosure from other institutions. The MDBs and IDFC have committed to tracking their climate mitigation activities according to a set of Common Principles. Developing expertise in climate disclosure can also enable MDBs to support wider economy disclosure efforts.
To determine which activities are eligible for green investment, DFIs can use the MDBs and IDFC’s joint Common Principles for Climate Mitigation Finance Tracking. These have been updated to exclude activities that reduce emissions but lock in emissive technologies over long periods of time. However, the Common Principles only explicitly exclude coal and peat-fired electricity generation. While they should be strengthened to include scientific emissions thresholds for energy generation and to exclude all unabated fossil fuel energy, in the meantime this lock-in exclusion should be interpreted as excluding fossil fuel energy generation, as a precautionary approach.
DFIs can also play a critical role in financing adaptation, similar to that of governments, see Finance. However, in 2019 mitigation made up 76% (USD 46,625 million) of climate finance and adaptation only 24% (USD14,937 million). Increasing the financing going to adaptation, and embedding climate resilience requirements into all projects is vital for MDBs to help meet global adaptation and insulate their investments from climate-related risks.
An example of how MDBs could increase adaptation financing is provided by the African Development Bank’s Adaptation Benefits Mechanism. Adaptation project developers can sign off-take agreements with public, private and non-profit actors for payments upon delivery of certified adaptation benefits and use those agreements as collateral for achieving equity and raising finance. This provides an additional revenue stream to finance adaptation.
EM countries are likely to be in need of debt relief to have the fiscal space for transition. In addition to debt for climate or debt for nature swaps, seeFiscal policy – reorient flows, MDBs could also link debt relief to climate conditionalities. For example, debt relief could be dependent on climate mitigation commitments or achievements.
Development banks can also play an important role in climate-related data provision. For example, the IMF Climate Change Indicators Dashboard provides climate data alongside government policy and financial risk indicators. Such data provision is particularly crucial for EM governments and central banks which may lack the capacity for data collection to evaluate investments and carry out stress testing.
Crucial role of blended finance to increasingly leverage private finance
Blended finance is an important tool as the structure provides support for the beginning to end of project. The DFI provides concessional financing to tackle, but not eliminate, a project’s investment risk that could otherwise prevent commercial bank lending.
In blending, the DFI can provide grants of capital (either refundable or gifted) and/or equipment and training. These grants significantly reduce project risk for the commercial lender. To further reduce risk, the blended finance deal could also involve a guarantee. If the DFI does not have high enough income, as may be the case for some NDBs, it may have to bring in government funding for the guarantee. DFIs can also help structure public sector blended finance deals.
De-risking facilities paired with other blended finance instruments can further increase financing flows. Alongside private liquidity provision and development banks’ risk transfer, government institutions can provide free market risk hedging (i.e. interest rate risk, foreign exchange risk). These are crucial for large-scale transition financing, especially in emerging markets with limited access to long-term capital, providing long-term financing and protection from negative market fluctuations.
Blended finance deals are usually very complex and bespoke, making the deal process cumbersome. To accelerate green investment, blended finance needs to become largescale and repetitive. By establishing templates and frameworks for green blended finance deals, DFIs will have greater capacity to construct deals.