Multilateral financial institutions need a theory of change to deliver better climate finance

At COP27, climate finance gained a lot of attention, and so did multilateral financial institutions (MFIs). The reason is simple: the green investment gap (i.e. the gap between how much we need to invest in climate mitigation and adaptation and how much money is effectively flowing there) is widening. According to the Climate Policy Initiative, USD4.3 trillion of annual finance is needed, dwarfing the USD653 billion actually allotted in 2019/2020 (of which only USD49 billion was earmarked for adaptation). Countries still have no credible pathway in place to limit global warning to 1.5°C, and both climate change and related impacts are worsening.

In principle, finance is available: global assets under management reached USD110 trillion in 2021 and financial institutions are increasingly aware of climate risks, as shown by the growing number of initiatives (UN NetZero Assets Owners Alliance). So why is insufficient money flowing into mitigation and adaptation, in particular in emerging markets and developing economies (EMDEs)? The reason stems from climate policy uncertainty and incoherent signalling. No financial intervention, either public or private, can address climate change in the absence of credible economic and energy policies. Policy credibility is essential to make investors’ expectations and risk assessment self-fulfilling and these, in turn, are vital for redirecting capital into mitigation and adaptation.

MFIs can play a central role in addressing the climate policy-finance conundrum. EMDEs often have limited fiscal flexibility and face difficulty in accessing to international markets. Furthermore, they are frequently challenged by high public debt, inflation and interest rates, and face growing impacts from natural disasters. These challenges limit public and private investing in climate mitigation and adaptation. Poor or no climate response, in turn, can feedback into sovereign risk and financial stability, potentially leading to cascading risks outside of these countries.

Action by MFIs is urgently needed to deliver better climate finance. To do so, they need a theory of change, one which recognises that climate risks are forward-looking and that, in transition scenarios, the risk of carbon-intensive projects is higher than for low-carbon ones. Risk differential across scenarios should be reflected in the climate financial risk assessment of projects. Many MFIs that invest in climate finance have not yet internalised climate risks, with varying results in terms of climate impact.

An important step forward comes from the World Bank’s theory of change, which considers the conditions under which green financial sector initiatives can promote decarbonisation, the criteria for applicability and the conditions needed to maximise impact. The theory of change recognises the role of traditional instruments (e.g. public funding and soft loans) as well as new ones, such as green macroprudential regulations and monetary policies. These instruments can contribute to lowering the barriers that hamper the Global South in accessing climate finance, which currently include low liquidity, poor access to capital markets and limited attraction to private green investments.

Implementing a Theory of Change requires better data and models. At the heart of the Theory of Change stands the identification of science-based, standardised climate financial risk disclosure and risk assessment as enabling conditions to deliver more favourable cost of capital and borrowing for climate investments, larger capital flows, de-risking and social cohesion. Achieving these requires MFIs to become a main catalyst of quality and granular climate data, and of science-based metrics and methods for better climate financial risk assessment. MFIs are not alone in this process and could benefit from stronger collaboration with research, both for climate mitigation and adaptation.

Data available from international providers and used by MFIs to guide climate investments are currently characterised by low granularity, accountability and relevance. For instance, using Greenhouse Gas emissions or Environmental Social Governance scores in place of asset-level data for physical risk assessment is misleading. However, better data is not enough; MFIs need fit-for-purpose macroeconomic and financial models that embed the characteristics of deep uncertainty and endogeneity of climate risks, investors’ expectations about policies and feedbacks on firms, and the co-benefits of early climate policy. This is crucial because such models are used to guide countries’ structural reforms to invest in climate-change mitigation.

Effective climate finance in the Global South needs coherent climate finance in the Global North. MFIs can promote a successful implementation of the Theory of Change by fostering climate policy coherence at the global level, starting from their base in the Global North. The challenges for EMDEs in accessing climate finance stem from their debt history, carbon intensity of the economy and trade, and vulnerability to natural disasters. These challenges are also worsened by the lack of coherent climate policy and investment from the Global North in the South (e.g. environmental dumping). MFIs can and should enter this debate, starting with carbon border adjustment measures and climate-aligned debt relief.

MFIs have a central role to play, and thus a responsibility, in promoting effective climate finance for sustainable and inclusive development. The time to begin is now.

This article has been published first in French, in Le Monde. Access the article "Il devient urgent que la finance internationale fasse sa révolution" - Le Monde (18/11/2022)