Time to Turn Ambitions into Actions

Financial institutions are central to global efforts to confront the challenges of climate change and will be crucial in channeling the necessary financing. Emerging markets and developing economies must collectively invest at least $1 trillion in energy infrastructure by 2030 to mitigate climate change by substantially reducing greenhouse gas emissions, and a further $140 billion to $300 billion a year by 2030 is needed to adapt to the physical consequences of climate change, such as rising seas and intensifying droughts.

At the same time, banks, investment managers, insurers, and their clients must manage the uncertainties of climate change-related risks and the major economic disruptions that come with a global economy transitioning away from fossil fuels.

An IFC survey of financial institutions in emerging markets and developing economies finds that most will need increased technical and advisory support to develop improved governance, new financial products, and risk management practices that respond to economic and market shifts related to climate change.

Participants in the survey pointed to a number of specific challenges, including a scarcity of data to inform decisions, nascent regulatory environments, and limited capacity to offer appropriate financial products. Some also cited a shortage of climate-related investment opportunities, insufficient tools to measure and manage climate risks, and constrained access to long-term funding for climate finance.

However, there has been an increase in capital flows to emerging markets to support the climate transition from both private and public sector sources.

According to Climate Policy Initiative, the amount of climate finance reached $632 billion in 2019–2020 after a decade of steady growth. Public investment remains the biggest source of this funding, accounting for 51 percent, with multilateral development finance institutions (DFIs) being the largest contributor. Despite the growth in private sector investments in recent years, climate finance needs remain significant with considerable uncertainty around the size of mitigation and adaptation needs.

This survey finds, however, that the need for support is not just financial. Respondents pointed to shortfalls in board-level engagement within financial firms and deficits in regulation and data collection needed to manage financial systemic risks. Multilateral institutions will also need to consider providing more advisory services to improve technical capacity, good governance, and due diligence practices.

EXHIBIT 1

With respect to governance around climate risk, less than a third of respondents said their institutions have adopted most categories of key risk management practices related to climate risk. However, more than half of respondents said that they plan to adopt these management practices within two years.

The survey also asked institutions to report on board involvement in climate-related governance and whether senior management is driving tangible actions such as ensuring executives account for material climate-related risks when formulating strategy or investment decisions. About one-third of the respondents said their company boards are involved in taking such actions to “a very large extent” or “a large extent.”

Awareness of risk related to climate change is growing among institutions

Financial institutions and the businesses they serve are exposed to physical risks from climate change, such as damage to property, infrastructure, and land. They also face indirect exposure and contagion through the financial system via counterparties.

Added to this, they must prepare for transition risks from changes in governments’ climate policies, technological shifts, and unpredictable trends in the wider economy, such as changing consumer and market sentiment as societies move toward less carbon-intensive economic models.

While a minority—around 40 percent—stated they either “agree” or “strongly agree” that climate risk is one of the top three business risks, more than half of the surveyed institutions plan to adopt key climate risk management practices in the next two years. 42 percent said they are focused only on physical risks, 14 percent solely on transition risks, whereas 44 percent address both. (See Exhibit 2).

EXHIBIT 2

Exposure to sectors more prone to transition risk, such as energy or transportation, incentivizes financial institutions to rethink and actively adapt portfolio composition. In this context, many institutions are including climate considerations by implementing limits on exposure to certain sectors or excluding them altogether. There has been significant progress in reducing exposure to sectors identified as harmful to the global climate in the Paris agreements and other accords, such as the mining of thermal coal, the extraction of peat, and the use of these commodities for power generation. 76 percent of respondents indicated no exposure to coal and peat, while over 40 percent said they restricted their involvement in financing the extraction and use of these commodities for power generation.

Only around 40 percent of institutions reported that they carry out quantitative analysis of climate risks for their due diligence processes. Meanwhile, just 6–7 percent of respondents said they build balance sheet provisions, raise risk premia, seek climate risk insurance or other forms of risk-sharing mechanisms to manage climate risks in the lending portfolio.

Financial institutions need to turn ambition into action to boost climate finance

Meanwhile, the survey suggests that around a third of respondents see climate finance as a priority. Although the actual share of climate finance in financial institutions’ portfolios is still small, 90 percent said they expect it to increase significantly over three-to-five years (See Exhibit 3).

EXHIBIT  3

However, developing country financial institutions’ growing appetite for expansion of their green portfolios faces a number of hurdles. These include low or insufficient customer demand for climate finance paired with the limited availability of longer-term funding and a limited breadth of climate finance products. However, financial institutions have started to work on designing climate finance products, which mostly focus on energy (See Exhibit 4). This is an area where multilateral institutions can have a positive impact by providing expertise in designing a range of climate finance products and help expand financing for private-sector-led innovation and crowd in private capital.

EXHIBIT  4

Improved climate-related disclosure guidelines are yielding positive results

Heightened risk to the financial system related to climate change is prompting regulators to impose more rigorous requirements on financial institutions to disclose their exposure. Many new initiatives encourage financial institutions and corporates to disclose their exposures to climate change, and, and one initiative is the Task Force on Climate-Related Financial Disclosures (TCFD), created by the Financial Stability Board to develop a standardized set of financial risk disclosures related to climate change. Governments around the world have begun to codify aspects of the recommendations into policy and regulation, using the Task Force’s work as a foundation for climate-related reporting requirements.

Our survey revealed that while only about a third of respondents have adopted three or more of the Task Force’s eleven recommendations, the share is set to reach 76 percent in the next two years. This is significant given that in most jurisdictions the disclosures are voluntary. (See Exhibit 5).

EXHIBIT 5

Still, respondents reported several barriers to their progress in increasing disclosure of climate-related risk. Among the most frequently cited were a lack of tools for tracking climate-related activities, limited data availability, a lack of a defined methodology, and insufficient support from regulatory bodies.

Development finance institutions can boost preparedness with both financial and advisory resources

Development finance institutions can support the need by providing financial resources and expertise to strengthen governance, strategy, and investment portfolio assessments suited to climate challenges.

Respondents to the survey expressed a need for technical support in several areas including strategy, governance, climate risk management methodology, and the development of climate finance products (See Exhibit 6). Through their global and regional reach and expertise, DFIs can support a more robust regulatory framework by engaging with stakeholders and policymakers at all levels, helping to establish and advance global standards, and surfacing best-practice examples to help drive climate action across financial institutions.

A key obstacle cited by many respondents is a scarcity of data that would facilitate the deepening of financial markets, regulatory reform, and the development of best practice guidelines. International institutions can provide support to build databases that inform more effective decision-making and help ensure transparent monitoring of progress. One potential way to address this challenge will be to initiate collection of data on a regular basis via surveys administered by regulators, local agencies, and DFIs to show behavioral shifts and emerging trends across institutions in developing countries.

EXHIBIT 6

Authors

The study was led by Sebastian Veit (Operations Officer, Financial Institutions Group) and Khondoker Haider (Economist, Development Impact Department). Jeyul Yang and Volha Haurylenka were instrumental in conducting the survey, implementation and analysis.

Acknowledgements

This study was conducted with guidance from Manuela Adl, William Beloe, and Dan Goldblum. The authors would like to thank the management and staff of IFC’s portfolio financial institutions for their contribution to the surveys, as well as the many colleagues from different IFC departments, including Financial Institutions Group, Climate Business Department and Development Impact Measurement Department, who contributed to this report. In particular, we would like to acknowledge inputs and support from: Francisco Avendano, Peter Cashion, Nadia Chiarina, Yann Frederic Camus, Vincent Darcy, Ortenca Destani, Elena Gex, Aurele M. Houngbedji, Anup Jagwani, Roshin Mathai Joseph, Wenxin Li, Fredrica Lissakers Mayer, Ilona Morar, Chiemi Nakano, Quyen Nguyen, Pushkala Lakshmi Ratan, Irina Sarchenko, Beniamino Savonitto, Vladimir Stenek, Christopher James Vellacott, Elizabeth White, and Rong Zhang.

References

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