Climate change could impact financial stability

Ajay Sagar
Former staffer, Asian Development Bank

Environment is not a national asset. It's a shared responsibility of one and all. Responsible global citizens now realise that any adverse environment action may have a reaction outside of their national location with wide-ranging cumulative impacts. Natural disasters and climate related events in recent years have made responsible global citizens aware of it.

Financial regulators, policy makers, and senior functionaries, are now increasingly becoming aware that key infrastructure and industrial projects face the risk of either increased insurance costs on weather and climate related events or lack of credible insurers in the market even at higher costs. The question then comes up who will fund high costs of insurance or uninsured projects? Certainly, lenders will not be able to absorb these risks? 

Another risk for long-gestation projects would be uninterrupted and continued availability of climate change related insurance coverage for the project over the life of the project. While lenders provide long-duration finance for projects, insurance companies write insurance contracts on an annual basis. Projects would run the risk of naked insurance for climate change related events should insurance providers deny writing insurance contracts for adverse climate events in the future during life of the project. These days, both investors and lenders are looking at concepts of life of investment insurance or life of loan insurance coverage for adverse climate change events and natural disasters. This is a major risk that export credit agencies, bilateral lenders, project financiers and credit committees at commercial and investments banks are grappling with.

In the event insurance companies deciding not to offer such insurance or offer at unaffordable rates, perhaps, governments may have to step up efforts and end up taking these risks. But cumulatively, such an exposure could be enormous and beyond the capacity of governments. There is an urgent need to blend climate change related risk considerations in taking long-term financing decisions. While micro-risks tend to be ignored, macro-risks present a huge risk, including risk of national and global financial instability. 

Looking back, not more than a decade ago, who would have thought that climate change and environment would need to be factored in to investment, lending and insurance underwriting decisions. Now the risk of ignoring these risks is huge, as natural disasters have the potential of leading to systemic financial disasters which, in turn, would need to be absorbed by innocent tax payers, if left unchecked. 

A Task Force on Climate Related Financial Disclosures, led by the Financial Stability Board and other multilateral institutions recently came out with a report setting out recommendations on climate change and green finance related financial disclosures by businesses, investment, lending and insurance community. It's a welcome step, but it is still a work in progress. 

In addition, central banks across the world are being asked to step in and be prepared to consider green quantitative easing, regulatory capital incentives to financial intermediaries undertaking green finance, disclosures, and introduction of green financing instruments. Financial sector regulators worldwide will now need to decide on stability indicators that are directly linked to green finance and climate change and blend them into financial stability indicators. These are necessary to mitigate financial instability in the national or global financial systems and assist in policymaking. The recommendations need to be adopted sooner than later. The G-20 grouping is actively engaged in its implementation.

Another aspect that regulators may want to consider is the inclusion of green ratings together with credit ratings being provided by international and national credit rating agencies. Regulators and policymakers need to push for the setting up of green ratings that could be blended with investment and credit ratings. Investors and consumers will be better able to understand the nuances of climate change and resultant financial stability issues by having rating agencies focused on climate change and green finance aspects.

Work has just begun. A lot has to be achieved in the shortest possible time. Otherwise, we may end up passing a heavy burden on to our next generation. A lot, however, depends on an urgent sense of responsibility that global citizens, investors, lenders, governments, policymakers, communities and other stakeholders are willing to shoulder. The socio-economic system is at stake. The impacts will not be just limited to infrastructure projects but could also be worrisome for home-owners, industries, and businesses as they will also end up facing the same natural disasters, risks and adverse climate events without any insurance cover.

(Views are personal)