Are Climate-Related Financial Sector Policies Inclusive for All?

Temperatures in July of 2023 broke a grim record – for the first time in history, the average global temperature was 1.5 degrees Celsius warmer than pre-industrial times. Given this escalating shift in climate patterns, financial sector authorities are progressively incorporating climate risks and opportunities in financial regulatory and supervisory policy frameworks. As CGAP has previously shown, however, there is a clear risk that financial sector policies meant to respond to climate risk and green the financial system could unintentionally undermine financial inclusion, which in turn would reduce the resilience of the economy and the stability of the financial system.  This has already happened in several parts of the world. What’s needed is a comprehensive analysis and understanding among financial authorities – and funders – of the pathways through which risks may occur and the opportunities for mitigation and bolstering inclusion and growth. 

Temperatures in July of 2023 broke a grim record – for the first time in history, the average global temperature was 1.5 degrees Celsius warmer than pre-industrial times.

EMDEs' policy shifts toward greening the financial sector

Emerging market and developing economy (EMDE) authorities are introducing or repurposing various policy tools to safeguard financial stability and incentivize investment in green and low-carbon projects. For instance, authorities in Brazil, Egypt, and Malaysia, among others, have introduced mandatory environmental, social, and governance (ESG) or climate-related disclosure and reporting standards to help stakeholders such as investors and creditors understand how financial service providers (FSPs) and companies manage climate and environment-related risks and opportunities. Additionally, in 2017 Brazil’s Central Bank mandated FSPs to disclose climate risks in their capital adequacy computations, and the Central Bank of Kenya’s 2021 Guidance on Climate-related Risk Management has similar expectations. 

Emerging market and developing economy (EMDE) authorities are introducing or repurposing various policy tools to safeguard financial stability and incentivize investment in green and low-carbon projects.

Furthermore, green lending and banking guidelines and environmental and social risk management standards that encourage FSPs to integrate climate and environmental risks into their credit underwriting and operational activities have been introduced in countries such as Bangladesh, Indonesia, and Nepal. Some countries, including Colombia, Mongolia, and South Africa, have also introduced green taxonomies to harmonize the identification of sustainable economic activities and ensure that FSPs lend only to qualifying entities. There has also been a repurposing of credit allocation tools, including targeted refinancing lines and lending quotas, to channel green finance to priority sectors and segments in countries such as Bangladesh, Nepal, and Pakistan.

Some of these authorities have also adopted or are considering adopting international climate-related financial principles and standards, such as the International Sustainability Standards Board's climate and sustainability disclosure standards and the Basel Committee on Banking Supervision’s principles for effective management and supervision of climate-related financial risks. Moreover, many EMDEs, such as Malaysia, Ghana, and Mexico, among others, have joined the Network for Greening the Financial System (NGFS), a voluntary network of Central Banks and Supervisors, and are following NGFS best practices for managing environmental and climate-related financial risks and opportunities.  

Could some climate-related financial sector policies inadvertently exacerbate financial exclusion?

Evidence shows that FSPs in some countries have stopped serving certain clients living in climate-vulnerable geographies. Therefore, it is important for financial authorities to reflect on the following questions: 

• While disclosure requirements may encourage investors to fund FSPs that disclose how they incorporate climate and environmental risks in their credit underwriting procedure, can they also drive away some micro, small, and medium enterprises (MSMEs) that want to access credit but fail to provide climate-related data to the FSP? 
• Incorporating climate considerations in capital requirements may increase FSPs’ resilience to climate risks and thereby ensure financial stability, but could they also compel FSPs to reduce or stop lending to MSMEs and low-income households that are disproportionately vulnerable to climate change? 
• Credit allocation tools such as targeted green financing may make it cost-effective for FSPs to channel green finance to MSMEs, but can they also discourage FSPs that serve MSMEs from seeking out other funding sources or engaging in fundraising activities? 

To illustrate, when the Central Bank of Brazil required large banks to integrate climate risks into their capital adequacy computations, the intention was to ensure that large banks had sufficient capital to cover climate risks, and to discourage these banks from supplying credit to firms with high climate risks. However, a World Bank study found that while the requirement led to a lending reallocation by large banks away from climate-exposed sectors, the smaller banks expanded their credit supply and loan maturity to large polluting firms that the bigger banks rejected since the requirements for smaller banks were less stringent. This ultimately constricted the amount of credit available to small and medium enterprises. 

In the U.S., the federal government’s flood insurance program (which subsidizes flood insurance premiums for exposed segments, allowing them to obtain mortgage financing) actually reduced mortgage lending to low-income borrowers, according to a Federal Reserve Bank of New York study. The flood insurance program put the onus of monitoring the beneficiaries’ compliance with insurance mandates on mortgage lenders, who found this requirement burdensome and consequently reduced their lending to low-income and distant borrowers. Similar regulation in EMDEs may compound the adverse impact, given that FSPs in EMDEs generally have limited capacity to apply complex climate-related regulatory standards. 

Climate-related policies should also present opportunities for financial inclusion

By identifying and managing climate risks, FSPs become more resilient to shocks and ensure their stability.  A stable financial system can efficiently allocate resources and manage financial risks and is a precondition for inclusion and growth. For example, authorities can use climate-related financial policies to incentivize inclusive green investments to facilitate a just transition, allowing low-income households and MSMEs to access green solutions. 

A stable financial system can efficiently allocate resources and manage financial risks and is a precondition for inclusion and growth.

El Salvador’s proactive green finance guidelines, for instance, have spurred green finance, and, according to a 2022 Central Bank survey, 11 of the country’s 21 supervised FSPs offer green finance products such as green loans and green savings accounts. Similarly, Bangladesh’s sustainable and green finance policies have led to phenomenal growth in green finance innovations, including climate-related insurance and microfinance. Other countries have recognized Inclusive Green Finance (IGF) as a strategic priority in greening the financial sector. Notably, Papua New Guinea has developed a national IGF policy, and Jordan has incorporated IGF in its green finance strategy.  

Some global initiatives also recognize the impact that climate policies can have on financial exclusion and IGF. Particularly, the Alliance for Financial Inclusion (AFI)’s  “4P Framework of IGF” – provision, promotion, protection, and prevention – offers authorities a range of policies they can adopt to promote IGF.

Another example is the United Nations Secretary-General’s Special Advocate for Inclusive Finance for Development’s IGF Working Group, composed of senior experts from AFI, the Center for Financial Inclusion, and the Sustainable Banking and Finance Network, as well as other technical experts, which is driving efforts to help authorities understand the importance of incorporating climate considerations in financial inclusion plans and strategies as well as how IGF can support resilience and adaptation outcomes for low-income households and MSMEs. 

Where do we go from here? 

The potential unintended financial exclusionary effects of climate-driven financial policies highlight the need for a comprehensive analysis and understanding among financial authorities of the pathways through which risks and opportunities for financial inclusion may occur.  

But funders have a role to play, too. As they begin to understand the pathways through which unintended consequences may arise, they can be more intentional in their support of green finance programs to help mitigate negative unintended consequences and allocate resources efficiently. 

CGAP is exploring these issues and will develop a conceptual framework and gather evidence to understand how climate-related financial sector policies may impact financial inclusion.