Aligning Policy-Based Finance with the Paris Agreement
October 17, 2022
This paper discusses an approach for aligning policy-based operations (PBOs) from multilateral development banks with the goals outlined in the Paris Agreement. The Glasgow Climate Pact calls upon MDBs to accelerate the alignment of their activities with the Paris Agreement, but an approach for PBOs has not yet been determined. To be considered aligned, PBOs must promote long-term macro-fiscal stability and a just transition to climate neutrality by 2050.
MDBs are a critical source of finance in many developing nations, and as such play a large role in funding sustainable development and climate action around the world. The Glasgow Climate Pact called upon MDBs to accelerate the alignment of their activities with the Paris Agreement. Policy-based operations (PBOs) are an important aspect of these activities as they provide unearmarked finance to government budgets in exchange for policy and institutional reforms (“policy actions”), which have potentially far-reaching implications for Paris alignment as they influence countries’ capabilities to create an enabling environment for economic activities.
This paper explores the current state of Paris alignment among these PBOs through bank policies and evaluations, staff interviews, an extensive analysis of policy actions, and six case studies. Drawing on this data, the paper outlines some key recommendations for achieving Paris-alignment.
Current practice and procedure for risk screening in PBOs is not suited to prevent policy actions from undermining government capability to promote long-term macro-fiscal stability and a just transition to climate neutrality by 2050. Policy actions can create path dependence in climate-vulnerable activities (e.g., agriculture, fossil fuels) and delay urgent climate expenditures that would decrease overall transition costs. Diagnostics are not sufficient for determining a country’s macro-fiscal exposure to climate risks and do not systematically determine institutional capacity for climate action. Social impact assessments do not yet consider needs for a just transition in climate-vulnerable sectors.
Most PBOs, certainly all that aim to support long-term macro-fiscal stability, can support Paris alignment and countries’ development objectives. The macrofiscal overview, country dialogue, and development partner coordination that determine how PBOs are formulated afford an opportunity to support domestic policy coordination for ambitious climate action and harmonize development activities. However, evidence of climate-related reform benefits remains limited, and MDBs neglect mainstreaming Nationally Determined Contributions (NDCs) in development plans that primarily inform bank activities.
Multilateral development banks (MDBs) are developing a joint approach for Paris alignment (AfDB et al. 2018). Four MDBs finance policy-based operations (PBOs), which provide unearmarked finance to government budgets in exchange for policy and institutional reforms (“policy actions”). Policy actions have potentially far-reaching implications for Paris alignment as they influence partner countries’ capabilities and help create an enabling environment for economic activities.
Budget support accounted for US$139 billion (38 percent) of new MDB commitments in 2015–2020, from 10–25 percent in a typical year to 30–60 percent during a crisis such as COVID-19. More than three quarters of the 39 low-income countries currently at high risk of, or already in, debt distress were approved for a PBO from an MDB in 2020, mostly for emergency relief.
About This Paper
We suggest an approach for Paris alignment by conceptualizing the “do no significant harm” principle and exploring how MDBs can maximize ambition for climate action in PBOs. Recognizing that the amount and type of budget support influences the selection of reforms, we consider PBOs to be Paris-aligned if their policy actions are compatible with the following:
Do not undermine a just transition to climate neutrality by increasing macroeconomic, fiscal, or social exposure to climate risks.
Wherever possible, support and promote long-term macro-fiscal resilience to climate risks and a just transition to climate neutrality.
We interviewed 29 MDB staff and use a multipronged research approach. Based on an extensive desk review, we generalize an MDB framework for aligning the PBO process with the Paris Agreement in Section 2. In Section 3, we outline considerations for Paris alignment by examining policy actions in three policy areas that reported the largest volumes of MDB budget support in 2018–20. We apply our considerations to two case studies in each policy area to identify gaps in Paris alignment, which informs our findings and recommendations in Section 4.
To fulfill their pledge to align activities with the Paris Agreement, MDBs need to address gaps across the PBO process. We make recommendations for sector and country managers, project teams, and shareholders.