Is Climate Change a Big Deal for
Financial System?
by
Bandid Nijathaworn
Bank of Thailand
Presented at Bank Indonesia Annual International
Seminar on
“Macroeconomic Impact of Climate Change:
Opportunities and Challenges”
Outline
I. Why climate change is a big deal for financial system?
Macroeconomic impact, implications for risk and opportunities, and roles of the financial system
Assessing current progress in the financial system
II. Some thoughts on ways forward for financial system in emerging markets
Key principles on how to move the issue forward
Some practical problems and challenges for emerging markets
I. Why climate change is a big deal for financial system?
1. Macroeconomic impact of climate change, is thought to be large, but uncertain, thus posing risk to the financial system.
2. Economic transformation in response to climate change i.e., adaptation and mitigation will require the financial system to adapt by managing risk and exploring new business opportunities.
3. Financial system can be an agent of change i.e., supporting adaptation and mitigation, through its influence on resource allocation, developing
Macroeconomic impacts and implications for financial sector
Macroeconomic impact is expected to be large, but uncertain. Estimates from three
benchmark studies point to a mean GDP loss of about 0-3 percent of global GDP for 3 °C warming (IMF WEO, April 2008). South and Southeast Asia are among the regions most likely to experience the most negative effects.
Impact is tantamount to a major supply shock on the economy’s productive
capacities i.e., capital stock and technology. Expected effects include long-term output decline, higher cost and inflation, shift in relative prices, and declining productivity. Some economies could encounter balance of payments problems. There is also uncertainty about possible large catastrophic damages.
As the financial sector is related closely to performance of the macro economy, long-term implications for the sector i.e., insurance, banking, and fund management are significant through increased exposure to a variety of risks (both its own and through its clients), as well as possible physical damages to its assets.
Economic transformation, in response to climate change, will require banks to manage risk and explore new business opportunities
Three triggers namely: (1) regulations by Government; (2) mitigation and adaptation by the private sector; and (3) increased public awareness of the issue; will drive economic transformation toward a low-carbon economy. Such transformation will shift relative prices (away from carbon-based
technology), influence the patterns of demand and production (toward non-carbon, carbon efficient, and carbon-capture technology), and redirect financial resources to support the process.
Being a service industry, these forces will require the financial system to adapt through (1) managing risk and the impact of climate change; (2) assisting the transformation by developing supportive financial services, markets, investment, and risk management products; and (3) exploring
related business opportunities.
Financial sector can spur transformation and support
adaptation and mitigation in three main roles
Directly influence resource allocation by internalizing climate change in its core business decisions i.e. lending, investment, fund management
Indirectly influence resource allocation by developing supportive finance services, markets, risk management, and investment to assist adaptation (i.e. insurance, weather derivatives, cat-bond) and mitigation (i.e. trading of carbon credit and allowances)
Scope of opportunities can be large
Banks are changing ways they do business in response to
climate change
Pressures from bank stakeholders, i.e. customers, shareholders,
employees, as well as peer pressure are pushing banks to become more engaged with the issue.
In response, banks have paid attention to their own exposure to climate risk and put up a comprehensive climate strategy by incorporating climate
change-induced risk in business planning.
Assessing the current progress in the financial system
On direct lending and investment;
Climate considerations in lending
- Citi incorporates the potential costs of carbon in the firm’s financing of power generation.
- Merrill Lynch has specific policy on financing coal-fired electricity generation.
- Credit Agricole has hired a full-time carbon analyst to measure the financial impact of carbon constraints on European companies subject to E.U. Emission Trading Scheme.
- HSBC has called clients to disclose their carbon emissions and mitigation strategies in a consistent way.
Equator principles
- ABN AMRO, Barclays, Citigroup and WestLB worked with the World Bank to launch the
Equator Principles in 2003 which integrates environmental
considerations into project
finance. To date, 54 banks have signed on the Equator
On market development: Clean Development Mechanism (CDM) is the key driver of growth in primary and secondary trading in carbon market.
Assessing the current progress in the financial system
Primary CDM annual volumes (MtCo2e) by regions
0 3,000 6,000 9,000 12,000 15,000
2005 2006 2007
Voluntary market other
JI
Secondary CDM Primary CDM
Project-based transaction (million US$)
On CSR;
According to the survey1, most banks have done little or nothing to elevate climate
change as a governance priority.
– Out of 40 of the world largest banks, only 12 banks have board-level involvement in climate change initiatives – only 1 in Asia and in US, 3 in Canada, and 7 in Europe.
– Only 13 banks have specific climate-related policies or strategies.
However, board of directors and company’s CEOs consider climate change as an
issue they have a duty to address.
– Twenty-four banks have set greenhouse gas reduction targets for internal operations.
– A small but growing number of banks are calculating carbon risk in their loan portfolios.
Climate change risk becomes an important issue for corporate disclosure in response
to investor and other stakeholder initiatives.
– Thirty-four banks responded to the latest climate-disclosure annual survey conducted by Carbon Disclosure Project (CDP).
1. Douglas G.Cogan, “Corporate Governance and Climate Change: The Banking Sector”, A Ceres Report, January 2008.
Globally, the direction of response by financial institutions is positive, but still in an early stage.
Progress in Asia
There is limited progress in Asia
– Although China is main supplier of carbon credit in CDM, but the rest of Asia lags behind.
– Progress is hampered partly by inadequate supporting framework:
absence of clear policy framework, incentive structure, information and
knowledge of key players.
The challenge is how financial system in emerging markets can
engage more in assisting the adaptation and mitigation process.
Some thoughts on the key principles for moving the issue forward.
1:
Critical role of state and policy in ensuring global rule of the
market is clear and continuous beyond 2012.
2:
Government policy should focus on providing market
infrastructure (i.e., legal, tax, regulatory framework,
accounting, information) and ensure correct incentive
structure to internalize benefits from clean technology.
II. Some thoughts on ways forward for financial system in
emerging markets
3:
Climate change is a new paradigm, with many uncertainty.
A key strategy to deal with this is through market-mechanism,
that allows market to grow and innovate under the
incentive structure provided.
4:
Financial regulation should be neutral on the issue, focusing
solely on risk management capability of the financial system
(in handling the new risk and the new innovation), aimed at
maintaining soundness and stability of the financial system.
Some practical problems and challenges in developing the tools
At this time, the main tools are provided in the global financial market, but the access of emerging markets to this market, both as buyers and suppliers, are limited by its own capacity as well as the market nascent development.
For emerging markets, the key tools are likely to include:
– CDM presently offers clarity up to 2012, provides core demand for carbon credit that forms the core primary market and allows secondary and derivatives market to grow.
– Insurance market offers products for risk mitigation.
– Investment Fund market bridges carbon credit buyers (mostly CDM driven) to sellers who obtain funding for its production, and delivers carbon credit to the investors who are brokers or ultimate users. Many countries have set up such Investment Funds, as well as funds set up by supranational such as World Bank and by private banks.
CDM
Absence of key global infrastructure for production of carbon credit
beyond 2012.
Lack of legal recognition of carbon credit as tradable securities and
assets. Different tax incentives between countries leads to
unleveled playing field.
Lack of knowledge and awareness, including high search cost for
identifying sellers and matching trades.
Need to set up “a guarantee fund” to help banks sharing the risk on
lending to CDM-projects.
Bank lending and pricing
Uncertainty in cash flow from the projected carbon credit and the slow approval process by local authorities is a major risk to banks.
Lack of understanding in CDM and carbon trading market, both from the authorities and financial institutions
Investment Fund
Unable to buy carbon credit directly if not considered as security legally
Clarity beyond 2012
The need to develop emerging market’s own fund
III. Conclusion
Climate change is a big deal for financial system through;
1. Increased risk exposure from macroeconomic impact
2. Risk and new business opportunities with economic transformation
3. Financial system as an agent for change
The current progress in the global financial system is positive, but still in an early stage. However, progress in Asia is much less.
Key policy principles for moving the issue forward
– Clear global rule of the market beyond 2012
– Market infrastructure and incentive structure provided by the government
– Market-mechanism should be the key driver to deal with this new paradigm
III. Conclusion
There is substantial opportunity for the financial system, especially in supporting green technology and carbon trading market.
The following actions might be useful for start-up emerging markets;
1. Establish the country’s overall strategy on carbon trading
2. Ways to reduce searching cost by mean of centralized information
3. Educate all market players: auditor, regulator, banker, and producer
4. Provide tax incentive to build up the market
On market development: Clean Development Mechanism (CDM) is the key driver of growth in primary and secondary trading in carbon market.
Number of CDM projects in Asia by country
Assessing the current progress in the financial system
