Driving a virtuous cycle of inclusive green finance

Addressing climate risks and seizing opportunities to finance the transition to a sustainable economy are some of the most urgent and complex tasks currently facing the financial sector. Financial regulators and supervisors play a key role in guiding the financial sector to manage climate risks and mobilize finance for climate action more effectively. However, to ensure a just transition that makes sure vulnerable segments of the economy are not left behind – especially in developing countries – regulators and supervisors must consider financial inclusion when implementing measures to green the financial sector.

As CGAP has highlighted, climate change, the associated risks to the real economy and the financial sector, and financial inclusion are intrinsically connected. The dynamic links between them have the power to drive either a vicious or a virtuous cycle. Financial supervisors can make a difference by mitigating the former and setting in motion the latter.

Climate change threatens to disrupt businesses, reduce labor productivity, and increase costs of operating high-carbon assets. These effects may result in increased non-performing loans for banks, asset devaluation in financial markets, and underwriting losses for insurers. In response to these challenges, to reduce exposure, financial institutions may see an incentive to pull away from clients more vulnerable to climate change. This could include those not highly profitable, such as low-income and rural households and small and medium enterprises (SME) (see Figure 1).

While financial supervisors are increasingly taking actions to address climate risks, it is crucial that their policies are sensitive to goals for inclusion and proportionate to risks, size, capacity, etc. This helps avoid unintended consequences. For instance, environmental due diligence and the verification of ‘green credentials’ could raise transaction costs to the point that small-ticket customers become too expensive to serve. This vicious cycle occurs when financially excluded households and firms cannot obtain the necessary financing to invest in green technology and greater resilience. Their vulnerability to shocks can exacerbate the fragility of the economy and thus the financial system, leading to further financial sector retrenchment.

^{Figure 1: The vicious cycle of climate risk and financial exclusion}

Source: Knaack & Zetterli (2023)

Alternatively, policymakers can set in motion a virtuous cycle of inclusive green finance, greater resilience, and lower risk. This can be achieved by issuing risk-proportional climate regulations; lowering the cost of green due diligence through systemic solutions addressing information barriers; and expanding the reach of green finance to vulnerable sectors. These measures collectively increase the availability and affordability of green finance. Increased investment in climate resilience and mitigation in turn can reduce the risk the financial sector is facing, leading to improved risk-adjusted returns (all else equal). The outcome of this virtuous cycle is a more stable financial sector that effectively serves the real economy and is less vulnerable to climate-related shocks (Figure 2).
 

^{Figure 2: The virtuous cycle of inclusive green finance}

Multiple financial sector policies and measures can be designed to make green finance inclusive, comprising the following:

(a)   Establish green credit guarantee schemes – to facilitate access to green financing, with a focus on SMEs.

(b)   Create a green credit information system – a depository of climate-relevant information about borrowers to reduce information costs and make green credentials more easily available to financial institutions.

(c)    Develop climate-responsive insurance and disaster risk finance products – to enhance resilience against climate effects, including for the most vulnerable.

(d)   Apply financial inclusion considerations for a proportionate regulatory and supervisory framework for climate risk management, governance, disclosure, reporting, and green financing.

(e)   Integrate inclusive green finance topics into a comprehensive financial sector capacity building program, both for financial regulators and financial institutions – to internalize inclusive green finance as a cross-cutting theme.

For example, the Central Bank of Jordan expects to implement all the above actions in its recently launched Green Finance Strategy 2023-2028, which was developed with support from the World Bank.

Although green finance and climate risk management in the financial sector are rapidly advancing, practical implementation remains in early stages across many countries. Therefore, now is the time to incorporate the concept of inclusive green finance into strategies for greening the financial sector and ensure effective implementation. While it may not always be straightforward to simultaneously maximize financial inclusion, climate resilience, and financial stability, having all three objectives clearly in view will allow for effective conversations about the potential tradeoffs and is likely to result in better outcomes.

Special thanks to contributing donors to the Jordan Growth MDTF: the United Kingdom, Canada, Kingdom of Netherlands, Germany, and Norway with implementation support provided by the Reform Secretariat at Ministry of Planning and International Cooperation, as well as to the Climate Support Facility Whole of Economy Program, administered by the World Bank.