Aligning finance with the Paris Agreement – cutting through the noise

Public and private finance are getting serious about aligning finance flows to meet the Paris Agreement objectives but progress needs to accelerate and assessment methods to be improved. Paris alignment is about system transformation – or ‘better development’ that serves both people and the planet – rather than a narrow concept of project-based finance flow alignment, argues James Rydge, as he explains the concepts, approaches, progress to date and further actions needed.

Article 2.1c of the Paris Agreement states that the world needs to strengthen its response to climate change by “making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development”. However, although ‘Paris-alignment’ of finance flows is becoming a hot topic across the financial world, there is often confusion around what it will take to achieve this.

In a new policy paper we provide a high-level overview of the issues and necessary actions – with the aim of providing clarity for any finance actor who needs to understand and progress the Paris alignment of finance flows.

Widely differing methods and metrics for assessing Paris alignment and guiding investment decisions are constraining progress

Paris alignment of finance flows can first be considered at a strategic level to drive systemic change. In this context we need to ask if the public and private sector are doing what is needed to ensure that financial decisions take climate change into account and align with the objectives of the Paris Agreement. This is not yet the case and progress needs to accelerate.

Crucial to driving progress and systemic change are sound methods and metrics to assess Paris alignment of finance flows and guide investment decisions. Methods and metrics are emerging, both for assessing Paris alignment of finance flows and alignment of portfolios, with approaches shaped by what Paris alignment means to different actors.

For example, to be truly Paris-aligned, the private finance sector needs to take climate into account in all financial decisions. This requires the right framework so that the financial sector can allocate capital to manage risks and seize opportunities in the transition to net-zero, as described by Mark Carney. Such a framework includes shifting the financial system through the ‘3 Rs’ of Reporting, Risk and Returns, and mobilisation of private finance for sustainable infrastructure.

In contrast, the Multilateral Development Banks (MDBs) need to develop a framework for Paris alignment of finance flows that helps client countries deliver the full system transformation needed to achieve Paris alignment and the Sustainable Development Goals (SDGs) – more on this below.

A crucial issue faced by all approaches is the relatively undeveloped state of methodologies and metrics for assessing Paris alignment of finance flows, including a lack of comparability and consistency between methods and metrics, across and within actors. This is becoming a significant constraint to accelerating the transition of finance and meeting the objectives of the Paris Agreement. Efforts to develop robust, comparable and consistent methods and metrics, including a set of minimum standards, need a rapid ramp-up. If actors cannot be held to account for their financial decisions this blunts incentives to shift finance to decarbonisation.

For example, Paris alignment of finance will likely mean no new coal and fossil-fuel project financing, but it is currently difficult to assess actual finance flows by key finance actors – and these are still likely to be in the hundreds of billions per year to fossil-fuel projects.

A proliferation of initiatives – with MDBs and private finance leading

MDBs and the private financial sector are leading the work on methods and metrics (and are the focus of our paper). MDBs are jointly developing a ‘Building Block’ approach, consisting of six building blocks that they have identified as the key areas for achieving alignment with the objectives of the Paris Agreement. Building Block 1, for example, relates to mitigation projects. It uses five specific criteria to determine Paris alignment to categorise mitigation projects as “aligned”, “not aligned” or “unclear”. The MDBs are currently road testing this approach among themselves, developing joint case studies and building consistency. It will be crucial to learn, prior to the COP26 conference in 2021, more about how MDBs plan to progress and roll out the full methodology for all Building Blocks, including how their method encourages and assesses systemic low-carbon transformation in client countries.

Among the proliferation of private sector methods and metrics are green taxonomies and environmental, social, and corporate governance (ESG) standards – these are useful tools but they have limitations that need to be addressed, which again include a lack of consistency and comparability.

More dynamic, forward-looking ‘warming’ metrics are emerging as the preferred choice for assessing Paris alignment of portfolios. This is an outcome-based approach, where an estimate of the ‘temperature’ of a portfolio is calculatedand compared to a Paris benchmark, e.g. 1.5˚C of warming. The Bank of England, for example, recently reported the temperature of its corporate holdings. But again, with little consistency and correlation across the multiple emerging temperature metrics, much more work needs to be done to ensure convergence of key assumptions and principles underpinning the metric.

The bigger picture – supporting recovery from COVID-19 and enabling net-zero and ‘better development’ for people and the planet

While the work on methods and metrics is quite technical, it is important to recognise that Paris alignment is more than assessment and alignment of finance flows and asset allocations. The technical work is one (critical) part of a larger strategic picture. At the systems level, Paris alignment can be understood as the sufficiency of collective and individual support, and finance and investment, to enable a sustainable recovery from COVID-19 and the transition to net-zero across countries (including climate, nature, resilience, social and just transition).

In other words, this is about system transformation and alignment, or ‘better development’ for both people and the planet, rather than a narrow concept of project-based finance flow alignment. Alignment will not be attained through some ‘green’ projects and some ‘brown’ and incoherent policies and institutions. This does not, however, mean the technical work on methods and metrics is not important. COVID-19 increases the urgency of the technical work on methods and metrics to ensure a strong, inclusive, sustainable and resilient global economic recovery that is Paris-aligned, building the foundations for the transition to net-zero.

This systems perspective is particularly relevant for the MDBs and development finance institutions (DFIs), where their work on Paris alignment should be part of, and integral to, COVID-19 recovery and sustainable development strategies in client countries, and recognise the mutually supportive role of the SDGs.Country buy-in to Paris alignment is crucial. One way to facilitate this is through climate-friendly (Paris-aligned) and SDG-supporting country platforms. These bring together MDB/DFI and other development partner operations, including national development banks, to accelerate the creation of the policies, institutions and investments needed to achieve the objectives of the Paris Agreement and the SDGs.

In this context, the MDB Building Block methodology on Paris alignment must be developed in a way that enables MDBs to properly assess and implement the full system transformation needed to achieve Paris alignment.It will need to recognise that the entire development system needs to be aligned across short- and long-term strategy, policy, scaling up, institutions, etc., not just projects. To do this MDBs need not only to operate better as a system, but also individually, to ensure sufficiency of action to drive a sustainable recovery and transformation to net-zero and better development. This will need both board and shareholder buy-in.

The emerging MDB Building Block approach has the potential to take this systemic view, which can then be implemented by individual MDBs. For example, Building Block 4 considers support for client countries to develop low-emissions and climate-resilient long-term strategies. But to be consistent with full system transformation it will need to go further than what we currently know about the methodology. The European Investment Bank (EIB) is leading here, committing to Paris alignment by the end of 2020. The EIB’s experience will be valuable for developing and taking forward the joint MDB methodology.

Read the full report by James Rydge here: Aligning finance with the Paris Agreement: An overview of concepts, approaches, progress and necessary action