Climate change poses serious and urgent threats to sustainable economic growth, international security, and human health, which are acute risks for DFIs. Climate finance commitments made by MDBs began to significantly trend upward starting around 2017 (EIB 2022, p. 56). In 2021-2022, the Climate Policy Initiative (CPI) reported that climate investments from all DFIs totaled $364 billion (Buchner et al. 2023, p. 1). This is a portion of the total global climate finance volume of $1.2 trillion, which still falls significantly short of the estimated $8 trillion (and growing) in financing needed annually to address climate change (Buchner et al. 2023, p. 3). 

How DFIs Operate: Funding and Focus 

DFIs are typically capitalized with funding from their government shareholders. Increasingly, DFIs that have a particular focus on economic development, poverty alleviation, and sustainable impact have benefitted from capital from other international organizations or philanthropic funders. 

The capital, or shareholder’s equity, of DFIs, is often structured as a blend of paid-in and callable capital, contributions, and guarantees. In many cases, countries will subscribe a certain amount of capital to sustain a DFI. But typically, only a small amount of these pledges is directly contributed to the DFI (paid-in capital). The remaining pledges can be drawn in if needed and thus are considered so-called callable capital. This special capital blend gives DFIs balance sheets financial strength and creditworthiness precisely because of their capital source. Credit-worthy government shareholders such as the UK, Germany, France, or the United States, are considered unlikely to default on their financial commitments to these financial institutions. The resulting “halo effect” of these shareholders means that the credit ratings of DFIs are directly linked to their public shareholders, e.g. governments with their own economic strength and credit rating. This interconnection with its public funders enables DFIs, including all 30 MDBs, to leverage their strong balance sheets to raise additional capital from capital markets. Many DFIs issue bonds with investment-grade ratings, representing attractive investment opportunities for institutional investors.  

As an example, in 2023 the World Bank held 7 percent of paid-in capital ($21.8 billion) in comparison to 93 percent of subscribed but uncalled capital ($296 billion), serving as guarantees for investors (World Bank 2024 A, p. 38). Based on the World Bank charter, outstanding loans may not exceed the total value of the subscribed capital (paid-in and callable), reserves, and surplus. This constraint guarantees creditors’ repayment. Due to this, the World Bank Group maintains the highest credit rating (e.g., AAA by Moody’s) and can raise large amounts of additional capital for low interests ($43 billion in bonds in 2023) (Moody’s 2024, p. 5; World Bank 2024 B). Thus, only a small amount of paid-in equity is needed to leverage development finance through DFIs. 

DFIs utilize the additional raised capital to achieve their objectives through project finance and credit transactions with governments and public and private sector entities. Most DFIs provide this funding to public sector borrowers on concessional terms, and to private sector borrowers on quasi-commercial or concessional terms. Currently, the World Bank defines concessional loans as having a grant element of 35 percent or more, and many DFIs set and transparently communicate their sovereign lending terms regularly (World Bank). 

DFIs focus on large-scale infrastructure and real-sector assets (energy, transportation, agriculture, water), the financial sector (banks, other lending institutions, micro-finance), and investments in education, health, and housing. These are often long-term projects exposed to a higher risk, which the private sector does not typically like to bear on its own, and thus DFI financing is considered “additional” (AFD 2020, p. 6; CCSI 2021, p. 56; Nonay et al. 2022). DFIs often finance in the form of low-cost and longer-term loans, guarantees, or occasionally equity investments to further crowd in or catalyze other investors into a project. Additionally, many DFIs engage in trade finance by offering trade finance programs and providing insurance-like financial products. Many infrastructure projects focus on enhancing transnational trade.

Many of these institutions lend at sub-market pricing, provide longer tenors, accept subordinated terms, or forgo security requirements that are market standard, all to bring additional financial benefit to investments that are aligned with the institutions’ development objectives.  Many also bring additional benefits such as preferred creditor status or tax immunity when they invest in emerging markets. Fitch Ratings defines preferred creditor status as “a widely accepted principle under which MDBs are given priority for repayment of debt in the event of a borrower experiencing financial stress,” which can also mean that MDBs loans servicing “are protected against restrictions on foreign exchange” (Fitch Ratings 2018). Subsidies for MDBs can include income tax exemption and exemption from indirect taxes on goods and services (Buiter et al. 2022, p. 11).  Benefits like these are highly valuable for project developers and can attract additional co-financing and capital from other investors from the private sector. DFIs often share and bear risks in projects that other investors may not take themselves, and this can manifest in the investment product and its terms. 

Furthermore, governments utilize DFIs and their financial strength to support the economy in challenging situations. For example, the German development bank, KfW, established a COVID-19 aid program to support businesses, start-ups, students, and not-for-profit organizations by providing more than €50 billion in low-interest loans, which were distributed through Germany’s private banking sector on behalf of KfW (KfW 2020). Thus, DFIs are important financial actors to provide flexible and innovative financing for investments that can catalyze economic development and sustainability.

Climate Considerations for DFIs

The UN’s annual Financing for Sustainable Development Report delineates how DFIs continue to be the largest providers of climate finance (IATF 2023). In 2021, MDBs in low and middle-income countries had already surpassed the climate finance goal set for 2025, which was a collective total of $50 billion (EIB 2022, p. vi). Overall climate finance commitments from MDBs rose by more than 24 percent from 2020 to 2021, and adaptation finance increased to over $19 billion (EIB 2022, p. vi). A significant driver for this is the mandate of DFIs to support economic development. This is impossible to achieve without addressing climate change, as development investments (i.e., infrastructure) are directly impacted by climate change. 

Some notable examples of how DFIs in different regions have incorporated climate into their mandate and practices: 

• African Development Bank Group (AfDB): The Climate Change Action Plan, now in its third iteration (2021 to 2025), is the framework used by the AfDB for mitigation, adaptation, and green growth investments. By using shorter time horizons, this strategy allows the AfDB to recalibrate its goals and progress as needed, as well as expedite them.  Nine of the ten most vulnerable countries on the Climate Vulnerability Index are in Sub-Saharan Africa, so the need for agile strategies and action is critical. One example of the Climate Action Plan’s strategy is to achieve 100 percent of projects based on climate-informed designs before 2025—up from 77 percentin 2016 and 94 percent in 2022 (AfDB A, B). 
• KfW: The German BDB has a division responsible for macro-investments in the environment and climate protection (CCSI 2021, p. 29). KfW prioritizes investments that support environmental protection and climate adaptation (KfW 2023, p. 4). Based on an Exclusion List, projects that violate specific rules are excluded at an early stage (KfW 2019). In 2021, KfW also began adhering to sector guidelines from the Paris Climate Agreement, which became required for all new financing activities (KfW).  
• Inter-American Development Bank (IDB): IDB assists governments in developing regulatory frameworks to advance decarbonization agendas that consider potential transition risks and opportunities (Pelaez et al. 2023). This allows IDB to involve key stakeholder groups (e.g., governments, local financial institutions, companies in which they invest) in the process of developing climate risk solutions and policies. IDB’s target region of Latin America will be highly exposed to climate change, so the climate risk assessment for the IDB especially focuses on physical risks. This is explored further in the following chapter. 

Case Study: How the IDB Incorporates Climate Risk Considerations  

The Inter-American Development Bank (IDB) is one of the largest MDBs in the world, with $148 billion in assets under management as of December 2022 (IDB 2023 B, p. 5). It was established and mandated to support social and economic development in Latin America and the Caribbean. While the IDB is owned by 48 sovereign states, only 26 countries of the focus region can receive loans. Backed by callable guarantees of the member states, the IDB sustains a triple-A rating, which allows low-priced capitalization through bond issuances on the capital market (IDB 2023 C). To fulfill the mandate, the IDB focuses on infrastructure projects, social and educational programs, and financing of health institutions. 

Countries within the focus region are some of the most vulnerable to climate change (Ramirez et al. 2020, p. 4). For example, increased severe weather events, such as heavy precipitation, flooding, and multi-year droughts, are significant concerns (WMO 2023). Damages from climate change-related events in this region may amount to $100 billion a year in 2050 (Barandiarán et al. 2019, p. 6).

Since the beginning of 2023, every IDB project has been assessed for alignment with the Paris Agreement. The IDB defines this as “to be consistent with a country’s net-zero emissions and climate-resilient development goals. Financing activities must be compatible with the Paris accord’s overall long-term decarbonization objective (IDB 2021). From 2022 to 2025, the IDB set a climate finance target of total climate project funding amounting to $24 billion (IDB 2022, p. 9). In the 2021 Sustainability Report, the IDB states that 78 percent of all sovereign guaranteed funding approvals had climate-related components. In more detail, 30% of projects are categorized as climate finance while 70 percent of projects support climate change mitigation (IDB 2022, p. 7, 13). To track the climate finance progress, the IDB adopted a methodology commonly created and shared by nine of the largest MDBs (IDB 2022, p. 42). Emission reduction projects are strategically supported by cooperating with NDBs and commercial banks (IDB 2023 D). 

The regional development goals are identified in a rotating process every four to five years for each country. All country strategies are published on the IDB homepage (IDB 2023 A). Since many of these countries are strongly exposed to climate change, this is also reflected in the specific country strategy of the IDB. To mitigate climate risks, the IDB has implemented a methodology in their investment process to identify risks and opportunities for adaptation and resilience called Disaster and Climate Change Risk Assessment Methodology (DCCRA). As part of this, geographical maps with predicted climate change exposure are used. Furthermore, project-specific qualitative analyses are generated to assess the physical climate risk and impact (Barandiarán et al. 2019, p. 6). 

In 2020, the IDB published the Environmental and Social Policy Framework (ESPF), which includes an Exclusion List with activities that are inconsistent with the IDB’s commitments to address climate change, such as thermal coal mining or coal-fired power generation, upstream oil, or gas exploration/development projects (IDB 2020, p. 20). 

Additionally, the IDB’s engagement to fight climate change stands out by recent efforts to provide additional capital for sustainable development to its member states, by using so-called debt-for-nature swaps (Ecuador, 2023) or debt-for-climate swaps (Barbados, 2023). These innovative climate finance instruments enable the refinancing of government debt on better terms, accomplished through guarantees and risk-bearing agreements of DFIs and development institutions. Participating governments agree to utilize the savings of this refinancing process for conservancy (debt-for-nature) or mitigation and adaptation projects (debt-for-climate). A recent example of a debt-for-climate swap is the transaction for the Barbados government. The savings from the debt restructuring are used to finance resilient water infrastructure (Savage, 2023). 

While the IDB implements physical climate risk assessments throughout the investment process, climate-related transition risk remains to be integrated. More climate risk-aware governance could be ensured, e.g., by assigning a representative of the climate risk assessment team to the investment committees, and continuously extending exclusion criteria for projects that are non-aligned with the Paris Agreement. 

Recommendations for DFIs to Further Integrate Climate Considerations 

The WEF Global Risk Report 2024 estimates that the most severe global long-term risks over the next 10 years will be climate related (WEF 2024, p. 8). DFIs can play a critical role in addressing these risks through mitigation and adaptation financing by implementing comprehensive climate risk considerations—both physical and transitional—into country, sector, and project-specific assessments.

Among the broad collection of DFIs, the MDBs play a uniquely important function in catalyzing climate action, in part because of their mandate, and in part because of the multilateral nature of those institutions.  Unlike bilateral or national DFIs that incorporate host country objectives into their mandates (by definition), the MDBs are characterized by a broad developed country representation and broad recipient country representation. To further enhance climate action and investment flows through MDBs, many stakeholder groups have been calling for institutional reforms, a topic that was front and center during the recent World Bank & IMF 2024 Spring Meetings.  

The MDB reform agenda has been under discussion for several years, and focuses on improving MDB governance structures, objectives, and targets; operational effectiveness; and creating new financial instruments to mobilize public and private capital for climate investments. However, many of the current proposals under the MDB reform agenda are equally applicable to all DFIs.  As such, these proposals, coupled with efforts like the IDB’s to integrate climate-related financial risk into investment decision-making, could help to accelerate climate action among all DFIs, not just MDBs. The reform proposals include the following areas of focus: 

Increase in Lending Activities by Broadening MDBs’ Balance Sheet 

Many organizations advocate for increasing the balance sheet and subsequently the overall lending power of MDBs to further leverage climate action. This can be achieved through an increase in subscribed capital (paid-in and callable) or through attracting new shareholders. 

Callable capital, for example, serves to strengthen the balance sheets of MDBs because of the nature of the investors, where the governments backing is viewed as having the highest possible creditworthiness. With this type of shareholder base and their callable capital, the balance sheets of MDBs can be deemed extremely creditworthy, and able to be leveraged for additional capital markets raises, most often through the issuance of bonds. Thus, increasing the callable capital could enable DFIs to raise additional capital. This could increase DFI lending capacity and leverage the paid-in capital even more, without increasing the paid-in equity. The implementation of this proposal directly depends on the willingness of the donor governments and on how rating agencies will consider additional callable capital in the DFI credit ratings (Shalal 2024). 

Better Lending Terms for Climate Investments 

By broadening the balance sheet in this way, DFIs will then be in a position to have more capital to lend, to use that capital to bear and share more risks, and to offer better terms for projects with significant impact on development and climate change.  The terms of lending can reflect not only the realities of climate change, but also can be useful to incentivize climate-positive investment (both mitigation and adaptation), i.e. through pricing terms, tenors, more patient repayment terms, subordination to other lenders, and key clauses in loan agreements around when and how a borrower repays such loans.  

In the context of MDB reform, an example of a loan term that is not financial but equally impactful is the natural disaster clause (also known as the hurricane clause). This clause can be embedded in the contractual terms of debt instruments and gives countries the ability to defer interest and principal payments in the event of qualifying natural disasters. As discussed, climate change influences natural disasters to occur more frequently.

Disaster recovery is a long and costly process, so having a standard natural disaster clause embedded in a DFI loan agreement can strengthen resilience by helping affected countries through these events by reducing debt stress (Ho et al. 2021, p. 5; Wigglesworth et al.). 

Conclusion 

In summary, our research into how DFIs are addressing climate change illuminates the fact that DFIs are uniquely important providers of climate finance because of their mandates, their shareholder base, their ability to leverage their capital, and their ability to provide financing that can both bear and share climate-related risks but also can incentivize positive climate-related investment. 

A leading point in our findings is how DFIs manage the severity of climate risks, discussed in-depth using our case study of IDB. The implementation of the physical and transitional risks into the investment process is an important step towards long-term successful development financing. This may also help accelerate climate finance by steering capital toward the right projects. Although the focus and depth of climate risk assessment varies by institution, the trend for more climate risk assessments is growing.  

Overall, the sustainability efforts of DFIs should not be taken for granted and the discussed suggestions are only a few operational concepts that can help DFIs integrate climate-related financial issues into their lending to developing countries. Almost all DFIs can face conflicting priorities of their government shareholders, torn between economic development, financial sustainability, and climate considerations, but these are not necessarily tradeoffs.  In fact, not addressing the rising and accelerating issues resulting from climate change can undermine all efforts to support economic development and can erode other sustainability goals. This is further exacerbated by the risks associated with the markets that many DFIs operate in, i.e. instability or inflation, which can deter future investments and challenges in acquiring additional financing.  

There are more opportunities for DFIs to improve their operations in order to meet climate-related objectives. DFIs must strengthen their relationships with governments, the private sector, and each other to address the limited number of climate-related investments currently available. By leveraging these relationships, developed nations could provide impactful guidance for DFIs to improve their business models, take on more risk, and scale their investments (UN Expert Group, p. 32). Formalizing information sharing among DFIs and the private sector across borders is also critical. Currency risk should be prioritized by investing in emissions-reducing projects in developing countries or creating currency risk safeguards in lending practices (Browne et al. 2023). Reform proposals to strengthen the role of DFIs in fighting climate change are regularly tracked and published by CGD’s Multilateral Development Bank Reform Tracker (CGD 2024). These practices will be critical for DFIs to achieve the goals being set for climate finance and global sustainable development.

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