Climate: The EBRD leads by example in CEEMEA

Achieving alignment with the goals of the Paris Agreement on global warming is a challenge for banks of any stripe. Understanding their exposure to and impact on climate change is a hugely laborious and complex task in itself, let alone working out how to get to net zero.

For multilateral development banks (MDBs) the problem is compounded by the need to reduce greenhouse gas emissions while still fulfilling mandates to boost economic development in some of the world’s poorest countries.

While the leading global MDBs were quick to agree in principle to move towards Paris alignment, details on how to get there have been slow to emerge. The first detailed methodology from the sector was published this summer by the European Bank for Reconstruction and Development (EBRD), more than five years after the signing in Paris.

The fact that the EBRD was first out of the gate is partly a function of its unique remit – the bank is facing a particularly big climate challenge.

Although its mandate has expanded over the past 20 years beyond the former communist bloc it was set up to support, many of its 38 countries of operation are still grappling with the legacy of Soviet-era industry and infrastructure. Nearly half have a higher carbon intensity than the global average. Ukraine and Turkmenistan are three times as carbon intensive. Meanwhile, the likes of Azerbaijan and Kazakhstan are heavily dependent on hydrocarbon exports.

Other EBRD regions are at the sharp end of climate change. Floods in the western Balkans in 2014 caused more than €3 billion of damage in Serbia and Bosnia. The bank’s newer countries in the south and eastern Mediterranean (Semed) are already suffering water scarcity and heat waves.

At the same time, the EBRD’s experience and capabilities are in many ways well suited to meeting the climate challenge. Everyone from policymakers to bankers agrees on the urgent need to mobilize private-sector finance, which is what the EBRD was created to do.

“The investment needed to shift the world to a low-carbon model is trillions,” says Harry Boyd-Carpenter, head of the EBRD’s green economy and climate action (GECA) team. “Governments don’t have that money and if they did, they don’t have the capacity to deploy it. So most of it will have to come from the private sector.”

The EBRD was also the first MDB to be set up with an explicit environmental mandate, reflecting its founding in the run-up to the 1992 Rio Earth Summit, as well as recognition of the need to tackle the environmental legacy of communism.

Over the years this has seen the bank playing a leading role in cleanups of the Baltic Sea, Danube Basin and Chernobyl site, as well as acquiring considerable expertise in areas such as energy efficiency. It was also one of the first MDBs to start issuing green bonds back in 2010.

Nevertheless, climate finance remained relatively niche at the EBRD until six years ago, focused on hard physical infrastructure such as energy-efficient boilers and renewable energy projects. “Stuff you can drop on your foot,” as one banker puts it.

Then in 2015, in the run-up to the climate conference in Paris, the EBRD set out plans for a four-year Green Energy Transition (GET) programme. A target of 40% green finance as a proportion of total investment for every year until 2020 was set, a jump from 28% in the preceding five-year period.

Around the same time, the bank launched a green trade finance programme and Green Cities, an initiative to support municipalities in transitioning to a low-carbon future.

“There has been a realization in the past half decade that actually what we need to see is not only massive investment in capex that drives the transition towards a low-carbon and resilient economy but also deep behavioural change in the way that the economy, the financial system and businesses operate,” says Craig Davies, EBRD’s head of climate resilience investments.

The various green initiatives have produced impressive results. The GET ratio easily topped the 40% target each year, going as high as 46% in 2019. The Green Cities initiative has 48 municipalities signed up and has mobilized more than €3 billion, while the EBRD has supported more than €675 million in green trade finance.

Building on this success, the bank last year announced plans for a second GET programme that envisages green finance reaching more than half of annual business volume by 2025, as well as net annual greenhouse gas emissions reductions of at least 25 million tonnes over five years.

A hard commitment to align all the EBRD’s activities with the Paris Agreement by the end of 2022 followed in April this year and was approved by the bank’s shareholders at its annual meeting in July.

This “whole bank approach”, as the EBRD describes it, will cover everything from travel to pensions – but clearly the main focus will be on the bank’s financing activities, currently running at around €11 billion a year.

This is a much more ambitious commitment than the green financing one and will require a very different approach. As Boyd-Carpenter explains, being Paris-aligned doesn’t necessarily mean being green.

“Paris says is this project consistent with a transition to a 1.5 degree world,” he says. “If we were funding a vaccine factory, we would check that the project is efficient and using renewable electricity. That would give us comfort that it is Paris-aligned, but it wouldn’t count as green.

“You can’t be green without being Paris-aligned, but you can be Paris-aligned without being green.”

On June 1, the EBRD began screening all directly financed projects for Paris alignment using a new methodology. Key concepts include assessment against a list of aligned and non-aligned projects agreed with other MDBs, as well as country and sector low-carbon pathways, plus a lock-in test and shadow carbon pricing.

Inevitably, the methodology has attracted criticism from some quarters. Much of this focuses on the fact that, while the EBRD has committed to exit upstream oil and gas, it is still prepared to fund midstream and downstream projects in the sector.

Boyd-Carpenter vigorously defends this policy. “Even in the most aggressive net-zero scenarios, you don’t stop using hydrocarbons tomorrow,” he says. “If you just say: ‘I’m not going do anything there,’ you’re walking away from a really big challenge.”

That is the difference between MDBs and commercial banks, he adds. “If they want to take a ‘do no harm’ approach they can stay out of a sector,” he says. “Our mandate goes beyond that. We have to say we’re doing no harm, but we also have to be positively advancing things.”

He also notes that the most carbon-reducing projects the EBRD has done have all involved oil or gas. A landmark project backed by the bank that introduced natural gas into Cyprus’s electricity supply, for example, has saved 600,000 tonnes of carbon a year.

The EBRD believes similar reductions can be achieved by transitioning from coal, which many of its countries of operation are heavily dependent on for both heating and electricity, to gas. Coal accounts for more than 40% of primary energy supply in seven of the bank’s countries of operation.

Another major focus for the EBRD is the huge amount of outdated infrastructure across its regions, particularly in the former communist bloc. Gas transmission lines in central Asia, for example, are notorious for methane leaks.

“This legacy infrastructure is really dirty and inefficient,” says Boyd-Carpenter. “You can have a huge impact by cleaning it up.”

As he acknowledges, however, building new gas assets creates its own legacy, with the risk that countries get locked into using hydrocarbons – which is where the methodology comes in.

“It has been designed to make sure that what we’re doing is genuinely accelerating decarbonization,” he says. “A lot of projects will fail that test and that’s fine. But there will be some that will be critical and which will move things along.”

Another criticism of the EBRD’s approach is that it does not address existing exposures. The bank has no plans to exit holdings in its portfolio, which include loans to coal companies – although these are expected to run off by 2025.

“Our focus for Paris Alignment is very much on the flow of new investments,” says Boyd-Carpenter. “We obviously have a large portfolio of historic loans, but we’re not focused on those because frankly that’s not going to change the substance of the underlying project, which is already funded. What we’re focused on now is what we can do that changes things.”

Other critiques of the EBRD’s methodology are more nuanced. James Hawkins, senior researcher at climate think-tank E3G, warns that the bank needs to be wary of relying on low-carbon pathways set by governments.

“Decarbonization needs to happen sooner rather than later, so it’s important that low-carbon pathways have a primary reliance on readily available technologies like energy efficiency, renewable energy etc.,” he says.

“We would like to see low-carbon pathways that avoid an overreliance on technologies like carbon capture and storage or hydrogen.”

Hawkins would also like to see the caveats around carbon lock-in strengthened. “The EBRD needs to ensure that projects it's financing won’t lead to carbon lock-in, perhaps through the use of loan covenants or similar mechanisms,” he says.

He points to the EBRD’s purchase of 24% of a Zl1 billion ($254 billion) local currency bond issued by Poland’s Tauron in November 2020, which included financial penalties if the utility fails to meet targets on renewable energy installation and greenhouse gas reduction. The EBRD confirms that it is keen to look at similar structures.

However, the biggest gap in the EBRD Paris alignment methodology at present is indirect financing. This accounts for around a third of the bank’s business, mainly in the form of loans to banks and other financial intermediaries for on-lending to small businesses and households.

This clearly presents a much greater methodological challenge, given the number of ultimate funding recipients and the autonomy granted to the EBRD’s financial partners in choosing them.

The bank is working on a joint methodology with other MDBs, particularly the International Finance Corporation (IFC), which also works extensively with the private sector. An announcement on high-level principles is expected at COP26, while the EBRD plans to approve its own methodology for indirect finance in the first quarter of next year and begin implementing it soon after.

What is already clear is that the focus will be on improving systems and processes at partner banks. “I think increasingly when we lend to a bank, we will help that bank put in place a climate risk methodology or its own version of a Paris-alignment methodology,” says Boyd-Carpenter.

The hope is that this will help to drive much wider change. “If we get it right, it will have implications that go far beyond our individual loan, because it will then permeate every aspect of that bank’s business,” adds Boyd-Carpenter.

The EBRD has already conducted pilot projects with a handful of clients, but the labour and resource-intensive nature of the work required quickly convinced bankers that a more systematic approach was needed.

The bank is therefore setting up a corporate climate governance facility backed by donor funds and supported by its climate risk and governance team that will place consultants with clients to provide technical assistance. The facility will be available to corporates as well as partner banks but is seen as particularly applicable to the latter given the number of institutions involved.

As Davies notes, in Ukraine alone the EBRD has around 30 financial-sector clients, whereas in the agribusiness industry it has a dozen or so in total. “In sectors where we have a lot of smaller clients with greater needs, we need a mechanism that enables us to scale up significantly,” he says.

The bank is also grappling with the best way to engage with clients – whether to start at board level or to focus on helping banks to compile data on climate risks. Davies says there is no right answer.

“It will depend on the organization and the nature of the client,” he says. “Often you’ll need to get CEO buy-in to do anything. But the bottom-up approach is important because information is critical.

“We find that many of our clients, including partner financial institutions, are not collecting any relevant information. They don’t know how carbon intensive their portfolio is, let alone how to start disaggregating that by sector.”

Crunching the numbers is often an important starting point, he adds. “You can then put those numbers in front of the board and demonstrate their exposure to high-emitting sectors.”

There is clearly a lot of work to do. A survey of the EBRD’s partner banks earlier this year revealed that just 43% of the 134 financial institutions that responded considered the impact of their portfolio on climate change as a potential source of risk. More than a third of those contacted did not respond. In addition, more than 40% of respondents either did not consider the impact of climate change on their operations or did not factor it into investment decisions.

As Davies notes, this speaks to the rapidly widening gap between the developed and developing worlds on climate risk. “In advanced markets we have seen rapid realization that climate change is a deep systemic source of business and financial risk,” he says. “In emerging markets it’s a very different story.”

Whereas countries such as France, the UK, the Netherlands and the US are all moving rapidly to integrate climate risk into their financial supervisory regimes, only half of the EBRD’s countries of operation have signed up to the Network for Greening the Financial System, a global grouping of regulators set up in 2017 to address the issue.

Similarly, of the 62 countries represented in the Coalition of Finance Ministers for Climate Action, just six – Estonia, Lithuania, Latvia, Hungary, Kyrgyzstan and Poland – come from the EBRD’s region.

This highlights another major challenge the EBRD faces in its push towards Paris alignment – bringing its clients and partners along with it. As Boyd-Carpenter puts it: “It’s no good the EBRD being Paris-aligned. The whole world needs to be Paris-aligned. And in our case our countries of operations need to be Paris-aligned.”

He adds that the bank is seeing “huge appetite for change” across the full spectrum of its countries of operations. “Companies, banks and regulators are all coming to us and saying: ‘We know we have to engage with this and we want to engage with it, how can you help us?’” he says.

There are hints, however, that not everyone is on board with its new agenda. Among the statements of the governors representing the EBRD’s shareholders, published at the time of the annual meeting, there were signs of dissent from several central and eastern European countries.

Poland and Czech Republic both stressed the need to support the use of gas as a transitional fuel, with the former going so far as to state that the Polish government “cannot fully support the resolution on EBRD climate ambition.”

Similarly, while welcoming the EBRD’s involvement in enhancing green financing, the Romanian statement included a warning that this must take into account the “specificity and level of development of each member country.”

Davies acknowledges that there has been a lack of enthusiasm for climate action in parts of the bank’s region. “I wouldn’t say we’re getting pushed back by our clients and countries of operation, but there are areas where we’re not seeing much interest,” he says. “People aren’t saying: ‘Go away, we don’t want to talk to you about this.’ But we are seeing cases where the response is muted.”

The EBRD is having to make the argument for Paris alignment to its partners, which it appears to be doing via a combination of dire warnings and promises of support. For those prepared to make the shift, the bank is offering policy help, as well as the possibility of increased investment.

“The extent to which countries and companies adopt the Paris agenda will have a huge influence on our business volume,” says Boyd-Carpenter. “The more that countries adopt a carbon price, impose a mandate for efficiency in cars or commit to cleaning up urban air quality, the more we’ll be able to invest there.”

At the same time, he warns that those that fail to get on board risk falling behind. “What we’re saying to our countries of operation is: ‘You’ve committed to the Paris goals and around 70% of global GDP is committed to net zero by 2050,’” says Boyd-Carpenter. “There’s already a carbon price in the EU and it is likely to become increasingly pervasive in the global economy.

“A country that says: ‘I don’t care about carbon because I’m too small or too poor, or I’m not really affected by it,’ is making a very big strategic mistake because the cost will catch up with them. High-carbon economies will be uncompetitive, expensive economies.”

This rhetoric is given urgency by concerns that the EBRD’s countries and clients could find themselves shut out from access to international finance given the rising pressures on international investors from regulators, asset owners and customers to take into account and report on climate risk.

“Most of the finance required for the climate transition will have to come from capital markets and private-sector investors, and they will require more and more information on climate performance and climate impacts,” says Carel Cronenberg, GECA associate director.

Once again, the problem goes back to data. As Gianpiero Nacci, GECA acting director, notes: “The reason why institutional investors are not investing in, for example, central Asia, is not just to do with political stability and country risk but also because the data is not available – or if it is, it is conflicting and not processed.”

Cronenberg adds that the risk is potentially even more serious on the climate adaptation side. “If I were an institutional investor, I would not invest in any agricultural projects in our Semed countries,” he says. “First, I know the climate risks are bigger there. But secondly, there may also be insufficient information available about what the actual climate risks are.”

This raises the possibility that vulnerable sectors and countries could be cut off from access to finance, he warns.

EBRD bankers also fret that even climate-aware emerging and frontier markets may struggle to access the resources required to meet ever-increasing requirements for climate risk reporting. As Cronenberg notes, even within the EU there is an estimated shortage of 100,000 climate experts.

“I’m very concerned that our countries may not be able to attract the right resources, the right staff and the right knowledge to take part in this global transition,” he says.

The hope is that the EBRD will be able to help bridge the gap by helping countries build their own capacity to acquire and process climate data, and by acting as a conduit for information between regional clients and investors.

“Cooperation is not only about financing the right project it’s also very much about sharing all types of information with our clients in order to help them to define their own climate strategies and their own market opportunities, and meet increasing reporting requirements,” says Cronenberg.

He adds that this is another reason for continuing to invest in high-emitting industries. “If we don’t invest in these sectors, they won’t have access to information and change won’t happen,” he says.

Conversely, the EBRD can share information acquired during due diligence processes with investors, says Nacci. He also notes that the bank’s project-level work could be used to trigger activities in its countries of operation, at a sectoral level if not at country level, that lead to creating services for data.

Improving the quality of client data will have the added benefit of helping the EBRD to meet the demands of its own investors, who are also under pressure from asset owners and regulators – particularly in the EU – to provide full disclosure on the climate risk in their portfolios.

As with other MDBs, the EBRD’s traditional focus on individual projects is proving problematic in an era where fund managers are increasingly taking a more holistic approach to investment.

“Our approach so far in terms of Paris alignment has focused on the project, but what investors increasingly want to understand is how the counterparty itself is transitioning,” says Isabelle Laurent, the EBRD’s deputy treasurer and head of funding.

The EBRD has taken steps to address the demand for full portfolio disclosure by signing up to the Taskforce on Climate-related Financial Disclosures – the first MDB to do so – but is increasingly facing tough questions from investors with net-zero commitments to meet.

“An individual project might work very well but if it’s in a high-emitting sector and the rest of the organization doesn’t have a robust credible pathway, then it may be deemed by others not to be Paris-aligned,” says Laurent.

This highlights again the tension between the climate agenda and MDBs’ development mandates. As Laurent notes, many of the EBRD’s most important projects are not meaningful in terms of climate mitigation and adaptation.

“Nevertheless, investors need to understand the context in which these are being done,” she says. “I think we need to be thinking more clearly about how to communicate the benefits of those as well, so that we don’t have a narrow focus only in relation to climate and Paris alignment.”

On the positive side, successfully striking a balance between environment and development, and playing a key role in the climate crisis, could offer MDBs a new lease of life – even a new raison d’être, some observers say.

“Green finance and sustainable development – and particularly the low-carbon transition – are one of the main reasons for the EBRD and other MDBs to continue to exist,” says one sector expert. “That is why their shareholders want them to keep going.”

Nacci echoes this sentiment. “Paris alignment and the frameworks it requires serve to define better the role of MDBs and allow us to remain a meaningful player – particularly when it comes to complex sectors and countries that are typically ignored or overlooked by deep global capital,” he says.