Acting on climate through the banking sector

Emerging market and developing economies (EMDEs) face higher risks from climate change than advanced economies. If not addressed, these risks could threaten their stability, negatively impact economic opportunities and development outcomes, and even set back decades of work to end extreme poverty and boost prosperity in these countries.

In addition to these greater risks, EMDEs also face a significant gap in financing for climate investment opportunities. Just 14 percent of global climate finance flows reach EMDEs other than China, even though these countries represent about one-quarter of global gross domestic product. Adaptation is particularly underfunded— only 16% of domestic and international climate finance in developing economies (ex China) is channeled for adaptation. Out of this small share, 98% is either public resources or official financing.

Moreover, while advanced economies and China can rely on domestic sources for over 90 percent of their climate finance, in other EMDEs less than half of climate finance is domestic in origin. Because banks dominate the financial sector landscape in EMDEs, with more than 80 percent of financial sector assets, they will inevitably have a large role to play in financing climate adaptation and mitigation efforts.

Yet at the moment EMDE banks provide far too little of that financing. According to a World Bank Group survey, climate financing is five percent or less of the lending portfolio for nearly 60 percent of EMDE banks—with 28 percent providing no climate financing at all.

To address these issues, banking authorities are beginning to adopt novel approaches to manage climate-related financial risks and enable climate finance.

Some progress to date has been made through several EMDE banking authorities’ innovative approaches to addressing climate risk. For example, central banks in Morocco, the Philippines and Mexico have been customizing their climate risk assessments to local extreme weather patterns involving droughts, floods, and typhoons. But much work remains to be done. A particular challenge for EMDE banking authorities is how to enable more climate finance without compromising their primary financial stability objectives, while also continuing to support financial inclusion for underserved groups. 

Most of the tools used by EMDEs to support climate financing are relatively new and empirical evidence about their suitability and effectiveness is still emerging. And of course, new tools will continue to be developed and tested.

Based on experience to date, the effectiveness of regulatory tools can broadly be divided into three categories: first, ‘win-win’ tools that support both financial stability and climate finance objectives, if adequately designed; second, tools that have the potential to enable climate finance, but for which ‘the jury’s still out’ until there is enough evidence to establish their suitability; and finally, tools that are ‘not recommended’ because they lack a proven record when it comes to mobilizing finance and also have a higher likelihood of compromising financial stability.

For example, transition planning (a win-win tool) is a promising measure in the prudential toolbox that can help banking authorities and investors better understand how a bank plans to align its operations with climate regulations and take advantage of green opportunities. The Philippines and Singapore have already started down this path.

There is growing interest among central banks in using so-called targeted refinancing operations—providing more favorable financing terms for climate friendly lending by banks—to encourage green finance. The Central Bank of Egypt operates various green credit facilities along these lines for farmers and renewable energy. The People’s Bank of China launched a carbon emission reduction facility that provides lower-cost funding for banks that on-lend to selected green sectors. Yet because this method could have distortionary impacts on financial stability, the jury is still out on it.

And credit allocation policies have been used to attempt to steer financial flows to green sectors or projects. The central banks of India and Bangladesh set quantitative targets for the share of a bank’s portfolio to be allocated this way. Yet prioritizing lending targets over risk management has had mixed success when previously deployed for targets such as small business financing, and it can create moral hazards and other risks. Consequently, green credit targeting is not recommended.

Emerging applications of tools to manage risk and enable climate finance

_{Source: World Bank staff
Note: Effective and appropriate deployment of “win-win” tools needs to be risk-based and well-designed; it also depends on prerequisites such as evidence on their application and reliable data. EU = European Union.}
 

No matter what mix of tools is employed to combat climate change, closing the climate financing gap requires broader policy support and leveraging financing sources beyond the banking sector. Fiscal policies including carbon pricing measures, the managed phase-out of fossil fuel subsidies, and the strategic deployment of renewable energy-related subsidies are critical interventions needed to align financial and policy incentives with climate goals. 

Capital and insurance markets will also need to be developed to provide access to long-term funding for new green technologies—as well as to support critical climate infrastructure and climate risk resilience instruments. Institutions such as national development banks and credit guarantee institutions can also play a major part. 

To meet the dual challenges of climate risk management and climate finance mobilization, banking authorities need to continue to address gaps and strengthen coordination regarding data, modeling methodologies, and disclosure standards. For example, the adoption of green and sustainable taxonomies, which define and classify investments and activities that support climate targets, will be essential. Yet today they cover only 10 percent of EMDEs, compared with 76 percent of advanced economies.

There is much more about EMDE financial sector trends, risks, resilience, and development in the recently published Finance and Prosperity 2024 Report.