Bandid Nijathaworn: Is climate change a big deal for the financial
system?
Speech by Dr Bandid Nijathaworn, Deputy Governor of the Bank of Thailand, at Bank
Indonesia's Annual International Seminar on "Macroeconomic Impact of Climate Change:
Opportunities and Challenges", Bali, 2 August 2008.
* * *
Thank you Chairman,
First, let me thank Bank Indonesia for the kind invitation. When I was asked whether I could
speak on climate change and the financial system, I felt the suggestion was a challenging
one, especially at this time when we need to build some momentum on this important issue.
My topic today is "Is climate change a big deal for the financial system?". Given the
limitations of time, I want to focus my discussion on just two issues. The first, is why climate
change is a big deal for the financial system, and the second, is to offer some thoughts on
how to engage the financial system going forward on climate change, especially in the
context of emerging market economies in Asia. Much of what I will say is still very much a
preliminary thought, which is still evolving.
Is climate change a big deal for the financial system? The answer is definitely yes, and there
are a number of good reasons why this is so. First, although uncertain, the macroeconomic
impact of climate change is thought to be large, which is likely to pose risk to the financial
sector, as well as to financial stability.
Second, economic transformation in response to climate change, as a result of an adaptation
and mitigation process, will also require the financial sector to adapt, by managing risk and
by exploring opportunities for business. Third, being a prominent sector in the economy, the
financial system can also be an agent of change, supporting the adaptation and mitigation
process, through its influence on financial resource allocation, through developing supportive
financial services, markets, and products, as well as engaging climate change in its own
business agenda.
Let me elaborate in more details on each of these points, starting with the macro impact and
implications for the financial system.
Conventional wisdom at this time is that the macroeconomic impact from climate change can
be large, but uncertain. For example, estimates from three benchmark studies, as cited by
the IMF, point to a mean GDP loss of about 0-3 percent of global GDP for a 3oC warming. In
Asia, South and Southeast Asia are to be amongst the regions most likely to experience the
most negative effects.
Such macro-impact is tantamount to a supply shock on the country's long-term productive
capacity i.e. capital stock and technology, leading to a decline in long-term output growth,
higher production cost and inflation, shift in relative price away from carbon-based energy,
and a decline in productivity. Some countries may suffer balance of payments problems if
they are financially unable to cope with the impact. On top of this, there is also uncertainty
whether a larger impact could materialize because of the potential for catastrophic damages.
Given the performance of the financial sector is closely related to the macroeconomy,
implications for the financial system could be significant through increased exposure of the
financial system to risk, both its own and through its clients, as well as possible damages to
its assets.
The key risk-driver includes market risk linked to large economic disasters, and operational,
reputational, political, legal and counterparty risk relating to defaults after a disaster. In
addition, there is also a business risk if it fails to properly incorporate climate change into its
portfolio risk management.
As for threat to financial stability, this would depend on whether the impact is slow-moving,
which can be offset by risk-management, adaptation, and financial response. Alternatively,
the impact could take the form of a series of catastrophic events that impair the operative
capacity of financial institutions.
Second, being a global problem, the collective response to climate change can set off an
economic transformation, in terms of the changing patterns of demand and production,
toward a low carbon economy that will require the financial system to adapt by managing risk
and exploring related business opportunities.
Three triggers will be key in driving this transformation: namely, regulations set by the
government, response by the private sector through adaptation and mitigation, and increased
public awareness of the issue. Such transformation will result in a shift in relative prices
(away from carbon-based technology), influence the patterns of consumption and production
(towards non-carbon, carbon-efficient, and carbon-capture technology), and redirect the
financial resources to support the process.
As I noted earlier, being a service industry, the financial sector will need to adapt by
managing risk, developing supportive financial services, and exploring business
opportunities. Both the threat and the opportunities that emerge will be a challenge for all
segments of the financial system i.e. insurance, banking, and fund management. In this
process, awareness, right incentive, and market mechanism will be key in determining the
pace of change.
Third, the financial sector can also be an agent of change, because of the three important
roles it can play. Firstly, it can directly influence resource allocation by internalizing climate
change in its core business decisions i.e. lending, investment, and fund management.
Secondly, it can indirectly influence resource allocation by developing supportive financial
services, markets, risk management and investment products that assist the adaptation
process, for example, through the development of insurance products, weather derivatives,
and "CAT"-bond, and also assist the mitigation process through trading of carbon credits and
allowances.
The scope for business opportunities on these two fronts are many, and are open for all
segments of the financial system, ranging from commodities services to corporate finance, to
investment banking, and retail banking.
And thirdly, financial institutions can also engage climate change in its business agenda as
part of the corporate social responsibility (CSR). Increasingly, we are seeing pressure from
stakeholders, pushing banks to become more engaged with the issue. And financial
institutions have responded by paying more attention to their own exposure to climate risk,
developing communication and business strategy that incorporates climate change, and
engaging bank management and employees on the issue as part of the corporate social
responsibility.
Up to now, globally, evidence of the financial system's response to climate change is
positive, but still very much in an early stage. On lending, for example, fifty-four
internationally-based banks have signed the Equator Principles which integrates
environmental considerations into project finance. Banks like Citi, Merrill Lynch, Credit
Agricole and HSBC have developed specific climate considerations on lending. But for
developing and emerging market economies, evidence on environmental lending by
domestic banks and by micro-finance institutions is more limited compared to international
development banks and subsidiaries of international banks.
On market development, Clean Development Mechanism (CDM) market growth is
impressive and this has been the key driver of growth in primary and secondary trading in
carbon market.
On the issue of CSR, banks have done relatively less to elevate climate change as a
governance priority. For example, only twelve out of forty of the world largest banks have
board-level involvement in climate change initiatives. But in terms of banking operation, a
growing number of banks are calculating carbon risk in their loan portfolios, with twenty-four
banks having set greenhouse gas reduction targets for their internal operations. Also, an
increasing number of banks are recognizing climate change risk in response to investor and
other stakeholder initiatives.
Judging from this evidence, while the response of financial institutions is positive, it is still
very much in an early stage. And in the case of Asia, the progress is even more limited. The
main supplier of carbon credits in CDM is China, while the rest of Asia lags behind. In Asia,
the engagement of financial institutions on climate change is scattered and not yet a
momentum. The progress is hampered partly by inadequate supporting framework that
includes lack of clear policy and incentive as well as information.
Let me now discuss some of the current problems in Asia and the prospects for the financial
system in emerging markets, especially in Asia, to become more engaged with the issue.
Given limited progress so far, the challenge is how to engage the financial system in
emerging markets more extensively on climate change. In moving this issue forward, a
critical role has to be played by policy, especially on the role of incentive and the
development of tools that can facilitate the response to climate change.
On incentive, a good starting point is to discuss the principles that would be important in
guiding the design of policy, which in my view, four key principles stand out.
First, the role of the states and policy are critical to ensure that the global rule of the market
is clear and continuous beyond 2012. This is because any uncertainty about the global rule
will only discourage future efforts and derail the momentum of the current efforts.
Second, policy at the country level should focus on providing market infrastructure that
assists adaptation and mitigation i.e. legal, tax, regulatory framework, accounting, and
information. But more importantly, correct incentive structure has to be put in place to
internalize benefits from clean technology.
Third, under the incentive structure provided, given many uncertainties surrounding climate
change, it is important that the strategy to promote increased engagement relies on market
mechanism to build growth and innovation. This is because the market would be in a better
position to assess and price risk-return tradeoffs more efficiently.
And fourth, financial regulation should be neutral on the issue, focusing instead on risk
management capability of financial institutions, especially the ability to handle new risk and
new innovation, with a view of maintaining soundness and stability of the overall financial
system.
Under these key principles, the actual design of incentive for specific economy would vary,
taking account of country's specific circumstances such as the state of economic
development, the level of financial deepening, and the strength of its policy institution.
Turning now to the development of tools for internalizing climate change in emerging
markets.
At this time, the main tools for internalizing climate change are provided in the global
financial market, but access of emerging markets to this market are limited by its own
capacity, as well as by the market nascent development. Under the current conditions, the
key tools for emerging markets for adaptation and mitigation are likely to be:
First, is CDM, which presently offers clarity up to 2012. CDM provides core demand for
carbon credit that forms the core primary market and allows secondary and derivatives
market to grow.
Second, is the insurance market that offers products for risk mitigation. Third, is the
investment fund market that bridges carbon credit buyers (which is CDM driven) and sellers
in emerging markets. Many countries have set up such funds, but less so in the context of
emerging markets' own funds. And fourth, is the direct lending by financial institutions in
emerging markets to promote energy-efficient projects and companies.
Response to climate change in emerging markets, therefore, can be judged in the
deployment of these four tools. Currently, the efforts remain scattered. Promoting the use of
these instruments will be key for building momentum in adaptation and mitigation. At this
time, however, there are many problems in emerging markets that remain to be tackled.
For example, in the case of CDM, existing practical problems include the absence of key
global infrastructure beyond 2012, lack of legal recognition of carbon credits as tradable
securities or assets, lack of knowledge and awareness including the high search cost for
identifying sellers and matching trades, and the need to set up a supportive "Guarantee
Fund" to help banks share risk on lending to CDM-projects.
In the case of bank lending and pricing, uncertainty in cash flows from the projected carbon
credit, and the slow process of local approval, is seen as a major risk to banks. Lack of
understanding of CDM and carbon trading market by financial institutions is also a factor
weighing on its progress.
In the case of investment fund, this is an area that has the strongest potential for private
investors' participation in supporting clean technology and energy-efficient companies.
Again, clarity beyond 2012 is needed for evaluating the longer-term economic payoffs, and
whether carbon credit is considered securities legally is an issue in some countries.
What I have mentioned are some of the practical issues that have emerged in emerging
markets, and need to be addressed in order to be able to speed up the process.
To conclude, climate change is a big deal for the financial system for a number of reasons
that I have mentioned. As for the response, the overall direction of the financial sector's
response to climate change so far is positive, but still very much in an early stage. The
progress, however, is more limited in Asia.
To promote greater engagement of the financial system, the issues of incentive and
availability of tools are important. On the former, key principles guiding the policy approach
should include clear global rule beyond 2012, the need for clear incentive structure by the
government at the country level, reliance on market mechanism to innovate and grow the
response, and financial regulation that is neutral on the issue. Under such policy setting,
there will be ample opportunities for the financial system, especially in supporting green
technology and carbon trading market.
Lastly, for emerging markets that are starting up on the issue, five actions along the following
lines could be useful. They are (1) establish the country's overall strategy on carbon trading;
(2) reduce search cost in matching buyers and sellers through a centralized system; (3)
create awareness and educate all market players; (4) provide the needed tax incentive to
build up the market, and (5) provide a clear legal framework. Actions in these five areas will
go a long way in avoiding many of the problems that some countries are now encountering.
Thank you.