Breakfast news: Digesting the climate finance

Climate change is transforming the global economy, and the financial sector as a result, an International Monetary Fund (IMF) official told the second Bayes Breakfast seminar this week.

Pierpaolo Grippa, a Senior Economist at the IMF, told invited guests that climate change poses significant physical risks and transition risks for the financial sector. The former include climate-related disasters such as floods, hurricanes and rising sea levels, which can damage assets and disrupt economic activity. Mortgage portfolios, for example, could face devalued collateral due to flooding while extreme weather events can lead to widespread economic losses, eventually impacting on the banks’ loan portfolios.

Chronic physical risks add to that challenge. These include sea level rise, and long-term temperature changes that affect industries dependent on stable climatic conditions, such as agriculture, tourism and construction. By ignoring or underestimating the financial impact of climate-related risks when valuing assets, financial markets risk mispricing and instability, Mr Grippa warned.

Yet analysis of these risks is particularly difficult because of their unprecedented nature, and hence the lack of historical data to measure their scale and impact; which explains the importance of scenario analysis in this field.

Simultaneous challenges

Governments, businesses, and the economy at large are also faced with the massive financial and economic impact of the transition away from greenhouse gasses – including through stricter climate policies, technological advancements, and changes in consumer habits. The sudden decline – and even disappearance – of certain industries could trigger financial instability including credit defaults and capital losses.

During his presentation, Mr Grippa suggested that action is needed on:

• Improving climate risk assessment through advancements in risk modelling, for example by including compound risks and a more complete representation of the transmission channels of climate-related shocks.
• Addressing the persistent issue of reconciling the long horizons of climate change and the economy transition with the generally shorter horizons considered by financial institutions.
• Enhancing the data infrastructure for climate risk analysis, including via collection of granular data on the geo-location of corporates’ assets.
• Strengthening green finance regulations to reduce greenwashing and boost investor confidence in sustainable financial products.
• Designing financial instruments that make green investments more attractive to private investors, such as public-private partnerships and de-risking tools.
• Encouraging international financial institutions to enhance their support for green finance in emerging markets and developing economies, including via risk-sharing mechanisms.

The presentation was the second in the Bayes Business School Breakfast Seminar series. These monthly events, held at the School’s Finsbury Square building, bring together senior leaders from industry, academia and the civil service to explore pressing challenges in the business world, spark research ideas and identify practical solutions.

Mr Grippa presented the approaches developed by the IMF to assess both physical and transition risks – incorporating them into financial stability assessments. This, he said, involves adapting and expanding the methods traditionally used for analysing the solvency of organisations and countries. However, the longer time horizons and high uncertainty associated with climate change, he said, pose additional methodological challenges.

Investors face adapt or mitigate dilemma

While finance is needed both to mitigate climate change and to adapt to it, the often uncertain return on investment complicates the financing of climate adaptation projects – such as building resilient infrastructure – which are intended to reduce the immediate impacts of climate change. Securing investment in cleaner energy sources and energy efficiency as part of a mitigation’ approach, he said, is more attractive to investors as it has clear economic benefits.

Yet while the green bond market has grown substantially in recent years, greenwashing continues to undermine investor confidence in green financial products, while the incentives built into certain instruments might not be sufficient to make a difference. That could be the case with sustainability-linked bonds that often impose minimal penalties for failing to meet environmental targets, reducing their effectiveness.

The geographical disparity in green finance levels also impedes the progress that emerging markets and developing economies can make in transitioning towards sustainability.

“Emerging markets play a pivotal role in the global energy transition. These economies account for approximately two-thirds of global emissions, with emerging market Asia alone responsible for more than half. Decarbonising these regions is crucial for meeting global climate goals. However, many emerging markets face financial and structural barriers that make climate finance less accessible.”

High interest rates, political and regulatory risks, and weaker institutional frameworks  combine to deter private investment in green projects in emerging markets.

Multilateral development banks, he said, could entice investors by providing risk mitigation mechanisms, such as guarantees and blended finance structures. He pointed to models such as securitisation structures that pool diversified assets from several emerging market banks, with multilateral development banks providing protection against the first loss in the resulting tranched structure. These demonstrate the potential for scaling up climate finance through innovative mechanisms, he suggested.

Dr. Angela Gallo, host of the event and Senior Lecturer in Finance at Bayes, welcomed the important points raised by Mr Pierpaolo, which sparked an insightful discussion involving students and invited external experts.

She added: "Bayes has a long-standing tradition of research, advisory work, and consulting in these areas. Our research centre, ETHOS, is a leading hub for corporate responsibility, with a particular focus on sustainability. Across all levels of study, we offer innovative modules on these topics, such as 'Climate Change and the World Economy,' led by Professor Bobby Banerjee. Wherever possible, these themes are integrated into our curricula.

"As members of the Centre for Banking Research, we ensure that students understand the critical role banks are expected to play in the decarbonization process, while also recognizing the challenges they face."

She concluded by highlighting that the multi-disciplinary expertise developed at Bayes over the past decade and beyond has paved the way for the launch, last year, of the MSc in Sustainable Management and Finance.