Climate change will affect finance institutions in various ways, especially if the global economy does not transition towards being low-carbon and climate-resilient (LCCR). A changing climate will expose certain assets and sectors to greater risks and uncertainties, but global climate mitigation and adaptation efforts will also create rarely seen opportunities for returns in others. What role can and should DFIs play in supporting and maximising the developmental returns of this transition?

DFIs have a critical role to play

DFIs can play a critical role in supporting the LCCR transformation in developing countries. Even where LCCR measures are more cost-effective than conventional options or offer wider advantages such as productivity gains or improved public health, they may entail higher upfront costs or be more complicated to plan, build and operate. As public backed impact investors, DFIs can take higher risk and deploy more affordable patient capital than private investors, so they are well placed to play a catalytic role in the LCCR transition.

Understanding climate-related risks using the TCFD framework

The Task Force on Climate-Related Financial Disclosures (TCFD) provides a useful framework for DFIs to understand how climate change is already affecting them, and how this is likely to evolve in the future. TCFD distinguishes between climate-related physical and transition risks. A warming climate – currently predicted to be between 2.4 and 2.7 degrees Celsius above pre-industrial levels – will increase DFI exposure to both acute (e.g. flooding) and chronic (e.g. rising sea levels) physical risks in nature-dependent sectors, such as infrastructure, construction or agriculture. Meanwhile, carbon-intensive portfolios in energy, transport or high-carbon manufacturing (e.g. cement, steel) will face greater transition risks from a rapidly changing policy and regulatory landscape, technological advancements and shifts in consumer behaviour. Slower rates of decarbonisation imply lower transition risks but greater physical risks, and vice versa.

DFIs have started to use this framework to understand their exposure to climate-related transition risks, mostly using proxies such as the extent of carbon-heavy assets in their portfolio or by measuring the avoided or sequestered emissions of their investments. Some DFIs also use qualitative assessments to identify climate-related physical risks at the investment level. However, there is much to be done to fully understand and strategically assess DFIs’ exposure to climate-related risks, which often move inversely depending on the pace of our LCCR transition. Given that DFIs have just embarked on this journey, we can expect that these approaches and practices will continue to evolve and improve over time.

Balancing an ‘inward-out’ with an ‘outward-in’ perspective

Forward-looking quantitative processes such as scenario analyses and stress tests can be used to assess future risks more accurately. Their adoption, however, is hindered by well-known barriers such as a lack of granular data, harmonised methodologies or common targets. DFIs can pool resources together to resolve these, but a more fundamental change is required in overall perspective. The current ‘inward-out’ perspective used by DFIs is focussed on the impact of their investment on climate change. To fully grasp the impact of climate change on their portfolios, DFIs need to adopt an ‘outward-in’ mindset to assess and manage both climate-related risks and opportunities.

As with risks, the TCFD framework can help DFIs understand the various opportunities associated with climate change. Some of these are already evident, as the price advantage of producing renewable energy or using electric vehicles has grown. Other transition opportunities will emerge as changes in the legal and regulatory landscape, further technological advances and climate-conscious consumer behaviour increase the value and growth of certain products, services and markets. Still other opportunities will reap their financial returns under a warming climate in the medium- to long-term, such as investments in resource efficiency or increased resilience to climate disasters. In total, bold climate action is estimated to carry impact opportunities that would add up to $26 trillion to global GDP by 2030 (Global Commission on the Economy and Climate, 2018).

Climate transition opportunities for DFIs

For these opportunities to be realised, structural transformation is required in five key areas: renewable energy, greener and more resilient cities, cleaner and more efficient industry, sustainable land use and wiser water management. DFIs have in the past played a crucial role in demonstrating the business potential of previously hard-to-enter sectors or markets, especially in renewable energy (RE) and transportation in emerging economies. What is less clear is whether continuous investment in these will maximise the future development impact of DFI investment and satisfy the need for DFI investment to be additional: rapidly declining cost curves in RE and electric vehicle (EV) technology, for example, continue to drive their commercial viability and therefore accelerate the allocation of private finance.

That is not to say that there is not a role for DFIs in these sectors. Although the RE and transportation sectors already represent over 80 percent of the roughly $600 billion (Buchner et al., 2021) in climate finance investment made in 2019/2020 there are subsectors where DFIs can play a leveraging role, such as in off-grid renewables. But the potential development impact is much greater in hard-to-abate sectors (such as steel, cement and chemicals) where technologies still need to be tried, tested and scaled before they can become commercially viable. Undertaking this kind of pioneering investment is part of the DNA of DFIs. There are also more immediate opportunities in the circular industrial economy linked to improved materials efficiency and recycling that DFIs could take advantage of.

Shifting the focus towards opportunities in adaptation

The second broad opportunity to secure additionality and maximise development impact is in adaptation and resilience. The scale of private finance that aligns with climate adaptation goals remains tiny, estimated at just $1-3 billion in 2019/2020 (Ibid). Meanwhile, investment needs are enormous. In the agriculture, forestry and other land use (AFOLU) sector alone – a major, but not the only, destination for adaptation finance – annual investment needs are estimated to be as high as $256 billion (Ibid). Further investment needs exist in water or buildings sectors, among others. The main issue is that DFI capital can only flow towards bankable projects, of which there is a shortage in adaptation sectors such as agriculture or forestry. Furthermore, where they exist, these businesses are rarely scalable or replicable. Initiatives, many of them private-led, are only at the beginning of tackling this perennial issue by creating specialised funds focussed on landscape or community-based financing models.

If DFIs support these developments, the economic, social and environmental returns could be enormous. Business opportunities in food and land use systems have been estimated at $4.5 trillion per year (Food and Land Use Coalition, 2019), mostly from transitioning towards healthy diets and investing in more productive and regenerative agriculture. Opportunities also exist for adaptation projects to capture and trade carbon in a market in which carbon prices are currently high. At the same time, hundreds of millions of people would enjoy greater protection from the ravages of climate change, such as through increased food or water security. Many adaptation projects would help DFIs meet global biodiversity and conservation targets, as well as anticipating further regulatory changes coming down the line under the Task Force on Nature-related Financial Disclosures (TNFD).

All this is part of the ‘outward-in’ perspective that DFIs need to adopt alongside the current ‘inward-out’ approach. This will ensure that DFIs can climate proof their operations against the physical and transition risks of climate change, as well as ensuring that they can maximise their development impact in opportunity sectors.

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References

Buchner, B., Naran, B., Fernandes, P., Padmanabhi, R., Rosane, P., Solomon, M., Stout, S., Strinati, C., Tolentino, R., Wakaba, G., Zhu, Y., Meattle, C. and Guzmán, S. (2021) Global Landscape of Climate Finance 2021, Climate Policy Initiative CPI)

Food and Land Use Coalition (2019) Mission Possible: Reaching Net-Zero Carbon Emissions from Harder-to-Abate Sectors by Mid-Century, https://www.energy-transitions.org/publications/mission-possible/#download-form

Global Commission on the Economy and Climate (2018) Unlocking the Inclusive Growth Story of the 21^st Century: Accelerating Climate Action in Urgent Time, https://newclimateeconomy.report/2018/

About the authors

• Samantha Attridge is a Senior Research Fellow and development finance specialist with a particular interest in innovative and blended finance, Development Finance Institutions (DFIs) and National Development Banks (NDBs). She is leading ODI’s research in these areas and has extensive technical understanding and knowledge in the use of development funds to de-risk private investment to mobilise private finance; as well as the operations of DFIs, NDBs and the impact of their investment.
• Dr Joseph Feyertag is a Research Fellow and sustainable finance specialist with a particular interest in mobilising private sources of responsible finance. He leads ODI’s research on assessing climate-related risks and impact, working with central banks, development banks and private investors to manage and mitigate these risks and maximise positive impact.

The published essay represent the views of the authors alone, and do not reflect the opinions of either the EDFI Association or its member institutions.