IMF report examines climate & stranded asset risks facing banks in MENA and Central Asia

A research paper written by an IMF team examines the readiness, risk and opportunities for the financial sector in the Middle East & North Africa (MENA) and Central Asia and identifies some areas that need particular focus. The evaluation of the region’s preparedness for the climate transition starts by looking at the sources of physical climate risk, transition risk, and the risk related to stranded assets on the region as a whole, including some that have been identified by financial sector supervisors and central bank Financial Stability Reports.

The discussion of physical risks includes several types that are impacted by climate change and identifies droughts and floods as those that are particularly impactful in financial terms for the banking sector. Overall, they estimate that bank stocks fall in the aftermath of climate disasters by around 1.5%, although the financial sector is robust enough to weather the impacts of a single climate disaster.

Through 2050, expected loan losses are projected at 1-1.5% of bank assets, assuming a slow rise in the frequency and severity of climate disasters. Total losses over the 27 years to 2050 are about 25% higher than the realized loan losses during the 40 years prior to this period, and could be understated because the figure doesn’t account for acceleration in the trend of physical risk such as from crossing climate tipping points or the increased severity of physical impacts associated with continued global average temperature rise.

The report continues looking into the transition and stranded asset risks facing the banking system in the MENA and Central Asia regions. These risks are assessed with a climate stress test using the financial impact of a carbon tax of $30 or $75 per ton of emissions as a proxy for a mix of policies to drive the transition, and the impact is noticeable. At the higher emissions cost, they indicate over 10% of bank loans representing $139 billion would be at risk of becoming non-performing. Even at the lower carbon price, which aligns with the region’s unconditional NDCs, the share of loans at risk would exceed 5%.

While high-emissions sectors are particularly impacted by the proxy of the carbon price, and have a sharply increasing number of loans at risk of becoming nonperforming, the impact is not only felt among a narrow set of high-emitting sectors. Other sectors also see a rise in the share that are at risk of nonperforming, which are defined as those not generating enough earnings to cover their interest expense after the cost of emissions is added to expenses.

Despite the substantial volume of loans at risk of becoming nonperforming under a carbon tax consistent with existing national climate commitments, it is essential to recognize the potential factors that may either under- or overstate the risks. On the side of the estimates overstating the financial risks is the lack of time specificity in these estimates with the backdrop of increasing climate action. A forecast of climate vulnerability is not determinative, and by contributing to stronger climate response, countries and financial institutions can mitigate the losses that end up being realized.

Although it is possible that transition risks could be overestimated if investments in climate change mitigation are made quickly enough and with sufficient scale, they are more likely to be under- rather than over-estimated. One reason why they may be underestimated is because the methodology uses the easiest metric of exposure – emissions of each sector – as the driver for financial risk estimates, which may not fully account for risk.

For example, utilities have a high level of emissions relative to their contribution to the economy, generating about 12 Kg of CO2e for every $1 of GDP. Although they take only a modest share of banking loans in the Middle East and Central Asia, the high emissions intensity means that utilities account for about half of the emissions intensity of regional loan books and have the highest share of loans at risk of any sector.

Other sectors have a lower share of emissions intensity in bank’s loan books based on the methodology used in the report, but it abstracts from the interlinkages between sectors, which is very likely to have an impact beyond the sectors where emissions are allocated. Utilities facing the realization of transition risk will not face those risks alone, and there will be spillover to their customers that will determine stakeholders’ evaluation of whether there has been a “Just Transition” or not.

Banks that finance both utilities and their customers will see the financial impacts of climate transition risk in the health of their finance to both. RFI accounted for this connection in our financed emissions database through presentation of both ‘direct’ and ‘indirect’ financed emissions exposure across the 206 banks that we estimated. Understanding the degree of intensity and interconnectedness of climate change was the rationale for how we produced the data, and can often be of more value than the point estimates for financed emissions that are calculated to meet disclosure requirements.

The rest of the report from IMF researchers evaluates some of the climate finance flowing to the MENA and Central Asia region, as well as making recommendations for policies that can help it scale up as far as it needs to. These opportunities for climate finance are made largely in mitigation today, often to renewable energy but also to demand-side measures such as energy-efficiency investments to help increase the share of low-carbon electricity over time even as demand grows. They will increasingly need to flow also to climate adaptation as the physical impacts of climate change rise.

Throughout the report, the authors highlight how much we know and how much more we don’t fully know about the way that climate risk will evolve over time. One of the important thru-lines that connects the policy recommendations of the reports is the need for expanding capacity around climate risk management and climate finance opportunities. The combination of physical and transition risks facing the MENA and Central Asia region elevates this need because the relevant skills can be applied in so many dimensions of the financial sector’s activities, as well as in public policy, regulation and supervision of the financial sector.