Reforming development finance to enable the sustainable development transition
Three ingredients for a demand-driven approach
This blog-post is conducted by I4CE and IDDRI.
The international community recognizes that the global development finance architecture is no longer fit for purpose. The World Bank, the IMF, and other institutions of the broader development finance system are today asked to invest more in global goods (specifically to fight against climate change and to preserve biodiversity, but their internal structure and the paradigms on which they ground their decisions have not changed since they were created with development – poverty and macroeconomic stability notably – as their main mandate. In this context, it should be no surprise that the response of these international institutions remains inadequate in terms of volume, structure and accessibility.
Three key gaps in international development finance
First, volumes of development finance are insufficient to meet global needs, as measured by a widening gap to finance the Sustainable Development Goals (SDGs), which was estimated at $2.5 trillion annually before the pandemic and rose to at least $4.2 trillion since then, according to the OECD.
Second, development finance often does not go where it is most needed for sustainable development. Notably, a majority of these international public resources goes to mitigation projects, while they would be critically needed to unblock adaptation projects and to address increasing climate-related losses and damages in developing economies, yet they remain difficult to finance. Among mitigation projects, development finance institutions tend to continue to mostly focus on “bankable” projects (as understood by the private sector with a focus on economic returns), such as renewables in electricity generation, instead of also supporting other sectors of the transformations which are equally important but more difficult to finance in a specific country context e.g. agriculture, land use and deforestation, household energy efficiency.
Finally, development finance remains difficult to access for some countries (partly due to high interest payments and an outdated risk perception) and often provided via loans that contribute to increasing the debt burden of developing countries and to limiting their fiscal space to address climate and development priorities. In 2021, 88% of the World Bank financing was in loans, while, according to the IMF, 19 of Africa’s 35 low income countries were already in debt distress or facing high risks in 2022.
This diagnosis should serve as a guide for the Summit for a New Global Financing Pact, which aims at “building a new consensus for a more inclusive international financial system”. It notably points to the need to adopt a demand-driven approach, ie an approach that puts at the center the needs of the recipient countries for their structural transformations required for a sustainable development transition
The work conducted by I4CE and IDDRI over the past few years on how to finance the transition in different developing countries has highlighted the value of adopting such “demand-driven” approach. From this work, we have identified three key recommendations: i) use country-driven integrated approaches, ii) a long-term perspective, and iii) a systemic / economy-wide perspective of the sustainable transition.
Use country-driven integrated approaches
Today, financing for sustainable development is guided by a silo vision that differentiates between development finance, climate finance – and inside climate finance, mitigation finance, adaptation finance and loss & damage finance – disaster risk reduction (DRR) finance, and more recently biodiversity finance. But this differentiation is artificial since development, climate, risks, and biodiversity are all related in ways that are specific to each country context. Therefore, only an integrated approach grounded on the specificities on each country can help identify the conditions to maximize synergies and limit trade-offs between these dimensions. It is therefore critical that countries define their specific pathways to best combine these goals taking into consideration current national circumstances, while also contributing to shared ambitions. These pathways may lead to different needs and priorities (financing instruments). For example, access to clean energy in developing countries is closely linked to development (as a condition to benefit from energy services for basic needs), mitigation (as a way to enable low-carbon usages) and adaptation (as a way for example to provide efficient irrigation for agricultural production and therefore decrease the vulnerability to climate hazards); it is only by considering the combination of these dimensions under specific country circumstances that adequate financing strategy for clean energy access can be elaborated.
Adopt a long-term transition perspective
While the time horizon in development finance tends to be longer than in the rest of the financial system, development finance institutions still lack an effective and automatic use of the reference tools that will enable them to take into consideration the transition of countries over the long-term. This requires to define clear long-term objectives and to backcast from there to define the changes that need to happen at different time horizons to reach that point in the future from the current situation. Such backcasting approach may lead to very different priorities as compared to the conventional approach which focuses on the options that maximize emission reductions in the short term at lower cost. This is particularly true when considering infrastructure investments faced with strong inertia, such as transport, buildings and urban infrastructure. Drastic transformations over the long-term towards public transport, more efficient buildings or better organized cities can definitely align development and climate objectives but these benefits are not necessarily visible under a forecasting approach considering short term effects
Support “economy-wide” transformations
Finally, acknowledging that addressing sustainable development requires systemic changes as highlighted by recent IPCC reports, priority should be given to support “economy wide” changes by opposition to the historical project-by-project approach conventionally adopted in development finance. Stéphane Hallegatte, senior climate change advisor at the World Bank, highlights that “we can no longer look at isolated investments, and must consider integrated strategies in which every sector plays a role”. Recently, examples of support for the transformation of a sector are appearing with the Just Energy Transition Partnerships (JETPs). Three JETPs were launched to support the transition of the energy sector in South Africa, Indonesia and Vietnam. These mechanisms represent a major step forward towards more transformative actions at the sector level. But development finance needs to go further and design financing activities with a view to transforming the economy as a whole – not just sector by sector. This will be key to make sure development finance goes in the sectors that need them the most. Engagement with countries will be necessary to identify these priorities, identify the most adapted financing channels (from concessional to guarantees aimed at mobilising the private sector for example) and coordinate efforts between development finance actors. Tools can support this discussion. These include national long-term strategies and associated financing plans. As indicated by Stéphane Hallegatte, they “clarify the long-term objective and determine the efforts of each sector, taking account of their interactions, for example the electrification of transport and the decarbonisation of electricity.”
Conclusion:
Reforming the global financial system for a sustainable development transition requires a change of approach. Long-term strategies (LTS) that countries have been invited to produce since the Paris Agreement, complemented by financing plans for the transition, combine the three ingredients listed above and are increasingly used to analyze climate change and guide decisions. Generalized to address the interlinked issues of sustainable development, they could be used to inform national decision-makers and development finance institutions of how to prioritize investments over different time horizons to avoid carbon lock-in and maladaptation.
Beyond this recommendation on tools, the perspective offered by the demand-driven approach can inform current discussions on the reform, including on questions related to internal governance of development finance institutions – increasingly raised by the global south from a climate justice and just transition perspective – to maximise their impact. Ongoing discussions on the reform indeed need to ensure that intended changes will not only make institutions perform better, but that they will ultimately support transformations at country level, building on the dynamics started by national stakeholders and putting justice at the center.
