The multilateral development banks (MDBs) are major providers of climate finance to developing countries. In the runup to final Paris Agreement negotiations, MDBs pledged to reach ambitious climate finance targets by 2020. However, most MDBs remain quite some distance from their goals.
Some observers assumed that a capital increase for the banks in 2017 or 2018 would make it easier to meet these targets. With the change in the United States administration, the size and timetable of capital increases for the banks has become uncertain. Yet the clock to 2020 is ticking. To deliver on their promise, the MDBs must do more with what they have.
One answer: use risk-sharing instruments like insurance, guarantees, first-loss positions and more to grease the wheels for more private-sector investment.
The importance of these tools came through in discussions at the G20 this summer, and was reiterated at COP23. The topic further got more attention at the One Planet Summit (also called the "Macron Summit") that took place in Paris last week. Facing this increased pressure to use the opportunities of de-risking for mobilizing private sector investments, what can the MDBs' recent Joint Report on Climate Finance tell us about how MDBs are responding?
Guarantees are often raised by the private sector and other stakeholders for their potential to catalyze more private investment. These instruments protect investors from a borrower's failure to repay and thereby improve a project's risk-return profile. Yet, the recently published 2016 report reveals that their use remains extremely limited, while other types of de-risking instruments are not addressed (see figures).
The reason for the limited use of guarantees in times of increased need for de-risking lies in a number of supply- and demand-side barriers, which we identified in 2012:
Accounting rules that require the full loan amount guaranteed to be retained on the balance sheet, which locks in capital that could otherwise be given out in loans.
Complexity of adding guarantees to the finance mix leads to longer processing times.
Lack of in-house knowledge and human resources.
Based on recent conversations with several MDBs—and just looking at the numbers—it's apparent that these challenges persist. Efforts to address these obstacles should continue. At the same time, the MDBs are also working to refashion de-risking approaches in ways that go well beyond guarantees.
Below is a snapshot of examples of recent de-risking efforts by different MDBs:
Bundling technical and financial support for de-risking efforts in the case of dedicated de-risking facilities like the new ADB Asia-Pacific Climate Finance Fund ( ACliFF), which bundles ADB support for a variety of different financial risk management products through one facility. Another example is the EBRD's risk sharing facility, which provides different risk-sharing instruments tailored to the local financial institution it serves. Similarly, the AfDB is developing a facility that aims at lowering risks for investments in agriculture value chains by financial institutions across Africa.
Bundling services in one-stop-shop programs such as the WBG Scaling Solar Initiative decreases the complexity of de-risking and shortens processing times.
Using multiple instruments can be useful to incorporate risk-sharing in traditional financial transactions and enabling private investment at multiple stages. An example is IADB-IIC's financing of renewable energy projects in Argentina, which are co-financed from public and private sources with a mix of concessional finance, A and B-loans, as well as equity. This way, risk is shared without locking in capital, because the funds are not retained but paid out.
Guaranteeing entire portfolios by covering a share of each loan, as done by the EIB, mitigates the side effects of locking in capital by scaling up the guarantee's impact directly.
A common feature of these approaches is the importance of concessional finance (e.g. via direct donor funding, multi-donor trust funds or climate funds). MDBs are reluctant to take on risks that might lower their credit ratings, so additional concessional finance with flexible terms can be critical for inducing MDBs to take on more risk, which is needed for innovation in the de-risking space.
More Visibility to New Approaches
As these approaches suggest, the set of targeted instruments for effectively de-risking and mobilizing private investments is more nuanced than the MDBs' joint reports illustrate. Also, the banks are actively experimenting to find de-risking strategies outside of the traditional "plain vanilla" approach of issuing guarantees and other traditional instruments. To give more visibility and transparency to these innovative efforts, future MDB Joint Reports on Climate Finance should incorporate them more systematically in the reporting. In parallel with other indicators, instruments should be disaggregated by bank and all the types of de-risking instruments beyond guarantees laid out.
In times of uncertainty around capital increases, flexible terms on the side of donors' concessional finance as well as transparent validation of approaches on the side of the MDBs is needed to identify and disseminate clear lessons from each bank's experiences. This will help improve the effectiveness with which MDBs mobilize private investments, advance their progress towards the 2020 targets and strengthen their role in climate finance.