Background to Climate Transition
Scientists say the world must halve global emissions by 2030 and cut them to net-zero by 2050 in order to prevent global warming above 1.5C, which could trigger catastrophic impacts across the globe.
But climate change already is fuelling deadly and disastrous weather across the globe. Nearly all of the world’s glaciers are melting faster. Hurricanes are stronger. Just this year, unprecedented rains unleashed floods across parts of central China and Europe, while wildfires are tearing across Siberia, the U.S. West and the Mediterranean.
According to the AFDB, Africa is the most vulnerable continent to climate change impacts under all climate scenarios above 1.5 degrees Celsius. Despite having contributed the least to global warming and having the lowest emissions, Africa faces exponential collateral damage, posing systemic risks to its economies, infrastructure investments, water and food systems, public health, agriculture, and livelihoods, threatening to undo its modest development gains and slip into higher levels of extreme poverty.
In order to avoid these disastrous consequences, there is a need to take deliberate and concerted actions to limit global warming to 1.5°C.
2015 Paris Alignment / Agreement / Paris Accord.
The Paris Agreement sets out a global framework to avoid dangerous climate change by limiting global warming to well below 2°C and pursuing efforts to limit it to 1.5°C. It also aims to strengthen countries' ability to deal with the impacts of climate change and support them in their efforts.
‘Paris alignment’ refers to the alignment of public and private financial flows with the objectives of the Paris Agreement on climate change. Article 2.1c of the Paris Agreement defines this alignment as making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development. Alignment in this way will help to scale up the financial flows needed to strengthen the global response to the threat of climate change. In essence there are 6 building blocks to this agreement, with specific timescales for action.
The specific role of Development Finance Institutions
Unlike, many foreign direct investors (FDIs), who’s investment mandates may preclude involvement in more “risky” ventures in developing countries around the world, Development Finance Institutions (DFIs) are willing to invest in Africa and other developing countries if the investment case is strong enough.
According to a Baker McKenzie’s report- New Dynamics: Shifting Patterns in Africa’s Infrastructure Funding, over USD 930 billion has been invested into Africa between 2008 and 2020 which has gone largely to infrastructural development DFIs are investors happy to seek investment returns from the poorest countries. Most DFIs have decades of experience investing in developing countries and know how to find investee companies with good corporate governance systems. They include, but not limited to:
IFC
FMO
CDC
AfDB
EIB
PROPARCO
SwedFund
The Association of European Development Finance Institutions (EDFI EDFI is the Association of European Development Finance Institutions, a group of 15 publicly backed institutions that provide financing and advice to private sector enterprises in countries where the need is greatest, while upholding high standards for the responsible financing of sustainable development, impact management, and transparency.
Over the past five years, EDFIs have committed €8 billion to climate finance in low- and middle-income countries.
Recent changes in the investment strategies to align to the 2015 Paris Accord means that some of these DFI’s have taken the position that they intend with almost immediate effect to exclude certain sectors of business and “run off” those existing investment positions by a specific date. This announcement occurred in November 2020, via the EDFI
In the lead-up to COP 26, and as countries around the world strive to achieve a sustainable recovery from the COVID-19 pandemic, it is more important than ever that EDFIs set a collective example for investors in developing markets. Accordingly, we make the following commitments as individual institutions:
1. EDFIs will align all new financing with the objectives of the Paris Agreement by 2022 and will transition our investment portfolios to net-zero GHG emissions by 2050 at the latest.
2. EDFIs will exclude new coal and fuel oil financing, and will limit other fossil fuel financing to Paris-aligned projects until generally excluding them by 2030 at the latest.
3. EDFIs will build on our track record in climate finance and the mobilisation of private sector finance by holding ourselves to ambitious individual targets and by reporting publicly on our progress.
4. EDFIs will invest strategically and provide assistance to our clients to support the development of Paris-aligned projects, and to promote green growth, climate adaptation and resilience, nature-based solutions, access to green energy, and a just transition to a low-carbon economy.
5. EDFIs will make climate related financial disclosures in line with high international standards, specifically adopting the recommendations of the Task Force on Climate-related Financial Disclosures.
6. EDFIs will embed climate action and climate risk management at every level of our institutions.
The above 6 commitments shall have far reaching consequences for developing nations, particularly countries whose economy is dependent on fossil fuel.
Specifically in relation to point 1 and 2, the mandate and intention is follows
Point 1
EDFIs will align all new financing with the objectives of the Paris Agreement by 2022 and will transition our investment portfolios to net-zero GHG emissions by 2050 at the latest.
● EDFIs will, at the project level, adopt harmonised methodologies and approaches to ensure that each new financing is aligned with the objectives of the Paris Agreement (hereafter, “Paris-aligned”) and consistent with the decarbonisation trajectory of the relevant sector or country no later than 2022, and will disclose the nature of such methodologies.
● EDFIs will, at the portfolio level, adopt approaches that will gradually decrease aggregated GHG emissions to net zero by 2050 at the latest.
Point 2
EDFIs will exclude new coal and fuel oil financing, and will limit other fossil fuel financing to Paris-aligned projects until generally excluding them by 2030 at the latest.
● EDFIs will exclude new fossil fuel financing, directly or indirectly through new commitments to investment funds and dedicated lending via financial institutions, in
coal prospection, exploration, mining or processing;
oil exploration or production;
standalone fossil gas exploration and/or production
transport and related infrastructure primarily used for coal for power generation;
crude oil pipelines;
oil refineries;
· construction of new or refurbishment of any existing coal-fired power plant (including dual); construction of new or refurbishment of any existing HFO-only or diesel-only power plant producing energy for the public grid and leading to an increase of absolute GHG emissions ; or
· any business with planned expansion of captive coal used for power and/or heat generation
EDFIs will restrict new fossil fuel financing that is not excluded by the foregoing paragraph (e.g. gas-fired power plants) by
limiting these to projects that are Paris-aligned
progressively adopting further restrictions, and
generally excluding them by 2030 at the latest.
Any subsequent new financing, in exceptional cases, will be clearly justified, specified, and publicly disclosed.
This is the intention. How it is enacted is in the following manner. “The following investment exclusions, as detailed above, are considered as a minimum common requirement by all EDFI members for all new Direct Financing (point 2 as described) / (Debt or Equity), for Indirect Equity through new commitments to investment funds, and new dedicated lending via financial institutions. Dedicated lending is defined in the following manner “Dedicated lending” is defined for these purposes as loans conditioned by a use of funds clause specifying that such financing will be used for one or more of the purposes described”.
Before the launch of the EDFI statement, several DFIs made commitment to either outrightly exclude fossil fuel financing or some form of restrictions to fossil fuel financng.
Source document: Do major DFIs finance fossil fuels? - Energy For Growth
Swedfund’s website states that since 2014 Swedfund has only invested in renewable energy.
EIB released a statement announcing that after end-2020, it will “align all financing activities with the goals of the Paris Agreement,” and will no longer consider new financing for unabated, fossil fuel projects (including gas) after 2023.
IFU no longer makes new investments in fossil fuel-based power generation as of 2021. However, it will continue to consider investment in ‘transitional’ technologies through 2023 — including hybrid gas and renewable solutions — with the goal of ensuring a “more reliable and smoother transition” to green technologies. These projects will need to meet development criteria such as aligning with the Paris Agreement, meeting acute energy needs, or securing broader energy access.
Some of the participants in the above table are not EDFI’s, but it is interesting to note the differences within the 15 EDFI entities when it comes to fossil fuels and perhaps future exclusions as stated in point 2 as mentioned earlier around intended commitment and time-scale.
Globally there are approximately 450 DFI’s who commitments and strategies and broadly similar to those already mentioned above.
So, by example and using DFI’s, their direct investments in refineries and coal plants in developing countries now may need to be re-aligned considering EDFI commitment. This will also apply to investment via local / regional financial institutions have specific investment commitments which a DFI has participated in directly.
Indirect / dedicated funding via a local / regional financial institutions appears to have escaped scrutiny at the moment, but we at Climate Transition Ltd believe that it is only a matter of time and perhaps, via country Nationally Determined Contributions (NDC’s), that this may change and may be aligned with similar timescales and consequences. Here is a table published in May 2021 indicating the position as at of publication of 29 DFI’s and their policy regarding Natural Gas Finance.
What are the potential impacts of such a course of action?.
EDFI’s in support and commitment to the Paris alignment needs to be part of, and integral to, long-term development strategies.
For EDFI’s, the development sector and the private sector, this means it is very important to come together and work with and support countries to develop their overall strategies for net-zero and their long-term development strategies (including shorter-term Nationally Determined Contributions (NDCs).
Potential impact
· Finance for fossil fuel project which is the mainstay the economy of Africa’s second largest economy (Nigeria) is now going to be limited or non-existent, making it impossible for projects like the Dangote Refinery, which obtained $2.25 billion from DFI, to access funds at a competitive rate.
· This move would lead to slow down of economic growth in countries that depend on fossil fuel. The Dangote project for instance is projected to add $19 billion to Nigeria’s GDP, this is about 5% of the country’s total GDP.
· The financial market may not be excluded from the fall back of this statement, as they would not be able to apply funding from DFIs to the fossil fuel sector. Most Nigerian Banks have exposure to the oil and gas sector at over 20% of their portfolio, and may soon be unable to fund this sector of their portfolio from DFI inflows. It is only a matter of time before DFIs preclude financial institutions with significant fossil fuel exposures in their portfolio.
· This commitment may lead to failure of project that are already under implementation but yet to be completed. The COVID 19 situation has caused the timeline for a number of major projects to be move, and this would cause cost overrun. Projects of this nature would already be facing a liquidity crisis and may need to restructure their outstanding exposures. It would be difficult for projects o this nature to get approval for their restructure request with these committed DFIs, leading to potential insolvency.
Important questions for EDFI’s, to ask include but not limited to:
• Do clients have a sustainable recovery strategy in place?
• Are their countries NDCs sufficiently ambitious and aligned with a sustainable recovery and long-term transformation?
• Are the NDCs anchored in a well-articulated growth and long-term development strategy?
• Has the NDC been translated into specific implementable programmes?
• What are the key gaps in policy, e.g. carbon pricing, and key institutional reforms that are necessary?
• What sustainable investments are needed and available in each country and what are the finance implications of going to the scale necessary
Investment client(s) portfolio alignment Temperature metrics for assessing Paris alignment of portfolios are rapidly developing. By example TCFD / PACTA and PCAF are coming to prominence globally and are being broadly adopted by certain institutions and regulators.
Their advantage is they go beyond a static assessment of Paris alignment at one point in time. They are a forward-looking, outcome-based approach to Paris alignment which estimates the ‘temperature’ of a portfolio and compares it with a Paris benchmark (e.g. 1.5°C).