Will climate financial stability risk assessment produce headwinds for climate finance in emerging markets?
The Financial Stability Board is developing an assessment framework to evaluate the risks to financial stability relating to climate change. In broad terms, it will translate a conceptual framework for how climate risks generate financial risks, and how these could cascade into a systemic risk.
Using the framework, the FSB outlined several types of proxies and metrics that could be used to evaluate the severity of different or multiple types of climate-related risks to financial stability. One challenge to the type of framework being developed by the FSB is that the prescriptions for large global financial institutions that follow from its conclusions could be misaligned with the interests of emerging markets and developed economies (EMDEs).
Many of the risk metrics are being developed with reference to developed economies and specifically reference the way that “global financial stability risks may arise from climate shocks in EMDEs [including those that] originate in the real economy and transmit internationally [such as] in some EMDEs that provide agricultural and mining products to the rest of the world”.
There is a clear connection between economic shocks in large EMDEs and global financial institutions and markets. Climate-related risks are among the types of risks that can spill over widely into global markets. However, often the application of macroeconomic metrics to identify sources of risks to global financial stability can have the impact – even if unintended – of raising barriers to flows of climate finance to EMDEs.
The FSB’s role is to identify ways to avoid global financial instability, and it approaches the issue from this perspective. The framework identifies ‘proxies’ for climate-related risk exposure for the region being considered. It follows up by identifying exposure metrics that relate climate risk to the financial sector. These issues are then linked together to identify the degree of risk to financial stability, incorporating information to blend climate risks with sources of systemic vulnerabilities that heighten the financial risk related to the climate risks and exposures.
Taken together, these metrics can provide an accurate picture of the parts of the global financial sector that are most at risk from climate change. Yet the actions that investors and financial institutions may imply from these types of metrics often have unintended and counterproductive impacts. For example, large global financial institutions may respond to the identification of heightened climate financial risk in EMDEs by ‘de-risking’ their climate-related exposures in these markets.
De-risking can benefit global financial stability while at the same time contributing to raising climate-related risks by making investments in mitigation, adaptation and resilience harder to come by. Global financial sector assets are concentrated in advanced economies and financial centres, which means financial stability will provide the greatest financial benefits to these same markets.
The consequence of de-risking away from climate-related risks will have the greatest negative consequences for EMDEs. To borrow from the FSB’s scenario description of the way climate-related financial risks are transmitted to the economy, the amplification of the impacts of climate-related shocks to EMDEs will come through reduced credit availability, increasing insurance gaps, and disruption to their own domestic financial sector institutions.
The conclusion isn’t to avoid producing assessment frameworks like that proposed by the FSB. Global financial instability will be widely damaging globally. At the same time, there are multi-trillion gaps in the amount of climate finance needed in EMDEs that are essential to achieving global climate goals. Formalizing assessments based on financial stability has the potential to be counterproductive if this undermines other efforts to increase flows of climate finance – and private climate finance in particular – to EMDEs.
