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Aligning Incentives for Climate Action

May 2, 2023

Studying a problem from within a box is not the same as stepping out of the box and looking at the problem from that new perspective. A whole plethora of options often open up. The current discussions on finance for climate or development and the role of the multilateral development banks (MDBs) is one such example. Don’t get me wrong. I’m all for financing for both climate and development. For me, they are both needed, and one and the same thing. But these are both solutions within the box.

Sustainable and equitable development is crucial for developing countries, who have historically, and also currently, produced a tiny fraction of greenhouse gas emissions globally. However, to achieve poverty reduction and development that is lasting and equitable, all long-term risks need to be better managed. Climate change is exactly one such long-term risk. Just look at Pakistan, where one prominent economist estimates that an additional 18 million people have been dragged back down below the poverty line partially as a result of the 2022 flood. Those calling for more climate finance, albeit principally focused on mitigation efforts, are also spot on. This creates incentives for the development and commercialization of alternative approaches to fossil fuel energy technologies, as well as technologies in other sectors which directly affect climate. Ultimately, no matter where the first efforts are directed, this will help to spur new approaches and bring down prices, so these technologies are increasingly accessible to everyone. As Vinod Thomas points out, looking at the world as one community, the ultimate adaptation measure to manage climate is mitigation.

It is the lack of discussion of solutions outside the box that is of concern. After all, if incentives can be better aligned across different stakeholders, this may potentially lead to faster climate action. For example, leveraging two major stakeholders better (the investors and the young) could facilitate faster action. By one estimate, the world’s assets under management totaled $126 trillion in 2022. ESG investment has been consistently on the rise, but fell last year, due to greenwashing allegations. Nonetheless, the world’s ESG fund assets are still a very small fraction of total assets, totaling $2.5 trillion in 2022. Yet, currently, what ESG entails is left open to interpretation as there are many measures but no credible internationally accepted standard. This is also detrimental to firms experimenting and trying to do the right thing, as this could equally be labelled greenwashing. Defining ESG, and ensuring that climate is included within that standard definition, in a simple yet easily monitorable way, becomes a smart way to encourage more private ESG investment, but also helps the recipients of that finance to understand better what is expected of them. In addition, it is young adults who are currently the outspoken voice on the need to act quickly on climate. Encouraging better labeling of consumer products, so that it is clear what their lifecycle greenhouse emissions are, will enable these young consumers to make informed choices. Such efforts will equally need to be accompanied by third party certifiers, and again, consensus and clarity on how to calculate these emissions, so a uniform approach is applied.

The MDBs have a key role to play in facilitating alignment of incentives amongst stakeholders, both in terms of investment, but also in terms of knowledge. For example, the recent Country Climate and Development Reports (CCDRs) really draw on the considerable expertise of World Bank staff to help governments understand better the interplay between short-term and long-term factors in affecting the quality of development. This is important, as all governments, in all countries, tend to primarily have a short-term election-based view of priorities. The MDBs equally have a role to play to encourage strong institutions in countries and in the global commons, so that the voice for the long-term comes through clearly and feeds into policy and investment choices.

Education is the first priority to ensure that people fully understand the full implications of climate change and what they need to do differently in the long term. This means encouraging inclusion of climate change and its implications as part of national educational curriculums in schools and higher education institutions, including medical schools; professional training bodies; and legal, journalism, and business schools. It also means encouraging civil society organizations (CSOs) to conduct third party monitoring to ensure additional finance is used efficiently and effectively over the long term for climate action. Ultimately CSOs need to keep track of and give a public shout-out to both private companies and government departments that do a good job in integrating the long term within investment actions and then sticking with it beyond election cycles or individual C-suite positions. Again, we have parts of the solution, such as the Financial Stability Board’s Task Force on Climate-related Financial Disclosures recommendations for private companies on disclosing climate-related financial risks in annual reports to shareholders. But long-term implementation is not seen through.

The second one is better aligning local and global benefits. The principal way to do this would be through the fiscal system. As the US nominee for president of the World Bank, Ajay Banga pointed out in his CGD conversation, jobs and basic human quality of life rights (clean air and water, education, and health) are front and center for most people. It is at the local level that these services are provided. Strong local governments also help to foster better accountability between people and their needs and rights, and those governing at a national level. This allows for better balancing and alignment of local and global benefits. If people pay taxes locally, their local demands and expectations are also stronger. Yet fiscal incentives at a federal level are often the drivers of climate innovation and investment, with a national focus, as demonstrated by the US’s Inflation Reduction Act. Federal governments are also key to ensuring redistribution of resources to poorer areas, to ensure more equitable development. The fiscal framework is the major piece that outlasts elected governments and creates the incentive framework for action. It is also a crucial piece for countries to have in place to weather uncertainties associated with long-term challenges, such as changing climate or pandemics. Hence, including an institutional analysis of this fiscal framework in the CCDRs to highlight its success (or otherwise) in encouraging equitable, sustainable, and climate-resilient development will open up a crucial dialogue, currently absent. It may even provide appropriate short-term (but with long-term implications) policy recommendations for collaboration with the IMF.

A third role for the MDBs relates to encouraging agreement on inclusion of climate within relevant global frameworks. Much as IFC has played a crucial role in establishing the Equator Principles to encourage environmentally and socially sustainable investments by the private sector, facilitating a broader dialogue and joint agreement on how to include climate in ESG criteria could encourage more flows to climate investments. The concept of calculating carbon emissions was developed initially in 1992 in the pilot phase of the Global Environment Facility (GEF), which was then housed at the World Bank. The methodology was developed with the intention of ensuring that a small amount of grant funds could leverage existing funds and provide the incentive at the margin to switch to less carbon-intensive technologies, and also for future GEF projects to generate information about the type of investments that resulted in lowering greenhouse gas emissions most effectively. However, we still use this approach 30 years later, despite the world being at a very different point on climate. Surely it is time to use the considerable knowledge of the last 30 years to develop a different approach that is easier to monitor (both for companies and third parties) and that will help to better leverage more ESG investment. Similarly, agreeing on and applying a common methodology for lifecycle analysis of products, so that all product labeling of greenhouse gas emissions is uniform, will empower the consumer to make more informed choices. The World Bank Group could, and should, play a leadership role on both these knowledge fronts.

Finally, a fourth role relates to demonstrating, through walking the talk, within MDBs how to integrate the long term into day-to-day administrative practices. With more climate finance within governments, different departments will vie for that same pot of money. Setting incentives within the organization to encourage different departments to work together (through appropriate budget distribution mechanisms, as well as staff incentives), labeling climate investments accurately, and keeping track of all climate investments across sectors, are just some examples. Inevitably what the MDBs do in-house is mirrored in their respective client departments. Finding and implementing solutions will help to ensure that all development finance is used in a more effective manner.

We can only change by better understanding and demonstrating development that is equitable, sustainable, and climate resilient, and aligning incentives to make that type of development easy. The MDBs, and their incredibly talented staff, have a key role to play in this transition.

Kulsum Ahmed is the Director of Integrated Learning Means and a former World Bank manager.