It is my pleasure to be with you today. My remarks will cover some of the main challenges that Emerging Markets and Developing Economies (EMDEs) face in the financial sector as sustainable finance continues to take hold, and why strengthening the global climate information architecture is paramount. I will also touch upon some of the regulatory aspects, specifically the role of macro- and micro-prudential regulation, as well as how climate-related transition risks and physical risks affect the banking sector. Finally, I will speak to some of the medium-term considerations that EMDEs will confront as they devote more of their attention to sustainable finance.
According to some estimates, ESG-linked debt issuance more than tripled last year to $190 billion. Sustainability-related equity fund flows also rose to $25 billion, bringing total assets under management to nearly $150 billion. ESG investments now form 18 percent of foreign financing for emerging markets (excluding China), quadrupling the average for recent years. This shows a positive trend in adopting sustainable finance in emerging markets.
Yet at the same time, it also raises questions about the risks of inaccurate valuation of “sustainable” assets due to the lack of consistent data, disclosure, and sustainable finance classifications. This poses a potential threat to financial stability. In this fast-moving environment, what could be done to ensure the creation of a true “asset class” across markets and countries? How can we achieve a good balance between the creation of “tight” standards/taxonomies and the feasibility of their implementation, especially in EMDEs? Emerging economies can no longer be at the periphery of global sustainable financial markets. There are critical needs for greater financing of mitigation and adaptation policies in these economies.
The latest report from the Intergovernmental Panel on Climate Change asserts that average annual investment requirements for 2020 to 2030 in scenarios that limit warming to 2°C or 1.5°C are three to six times greater than current levels, and total mitigation investments (public, private, domestic, and international) would need to increase across all sectors and regions. But given the size of the global financial system, there is sufficient global capital and liquidity to close global investment gaps. The main challenges are the barriers preventing the redirection of capital to climate action—both within and outside the global financial sector—and the macroeconomic headwinds facing developing regions. Also critical will be clear signaling from governments and the international community, including a stronger alignment of public sector finance and policy.
The positive news is that sustainable debt issuance has increased in emerging markets in 2021 to $190 billion. At the same time, the share of emerging markets in global bond issuance has risen in 2021, which is the first year that these economies have gained market share at the expense of advanced economies. The traction has been the strongest in Asia and the Western Hemisphere—and most notable for sustainability-linked bond and loan instruments.
This sharp acceleration has come after a mainstreaming in sustainable finance strategies in these economies, by regulators and stock exchanges. It has been driven by pandemic-induced demand, and green borrowing strategies. Some emerging markets have been active in implementing climate-related disclosure requirements, as well as issuing taxonomies. However, the financing remains insufficient and needs scaling up.
Apart from the absence of adequate carbon pricing, barriers to private climate finance in EMDEs often involve long timeframes, high upfront capital and transaction costs, and significant project and/or country risk.
The public sector can play an important role by providing public investment in infrastructure, improving data and disclosures, and incentivizing R&D in order to overcome barriers to climate finance in the absence of adequate carbon pricing that contributes towards generating incentives for desired investments.
Innovative financing approaches by multilateral development banks and private-sector investors, for example through providing equity and first-loss guarantees, as well as mezzanine financing structures, could provide potential avenues for removing barriers to private climate finance, especially in the interim until carbon pricing contributes to generating the desired investment incentives.
Implementing a global climate information architecture should be a foundational element in the development of sustainable finance markets in emerging economies.
Besides macroeconomic determinants, challenges in emerging markets include the limited size of the local investor base, higher risk premia in sustainable debt issuance, limited adherence to Green Bond Principles, and poor climate-related data disclosure. This is why strengthening the global climate information architecture is paramount. Current standard-setting work should fully take into consideration difficulties in data collection in emerging markets, while ensuring that company-level disclosures are mainstreamed across these economies.
The IMF is currently leading a joint project, with the World Bank, the BIS, and the OECD, to issue operational guidance on the G20 high-level principles for sustainable finance classifications. In our view, this work is all the more relevant for emerging markets, considering the unique circumstances they face in decarbonizing their economies and attracting capital. The Fund is also playing a leading role in building capacity and raising awareness about the key role of the financial sector and the deployment of regulations.
Let me now turn to the climate-related risks currently facing the financial sector, and the critical role that macro- and micro-prudential policy can play.
Falling asset values due to more frequent and severe weather events and the need to adjust business models in response to climate change mitigation policies can cause material losses to the financial sector. Some jurisdictions face acute physical risks, which may also be termed “hazards,” such as heat waves, storms, floods, or typhoons; and long-term changes in climate patterns—so called chronic physical risks—also exist. On the other hand, transition risks occur due to changes in climate policy, technological advances, and consumer and market sentiment during the adjustment to a lower-carbon economy.
In fact, physical and transition risks are intertwined.
The faster the transition, the less the expected temperature increase and therefore the smaller the physical effects of climate change. But the economic effects also depend on the pace and composition of the transition to a lower-carbon economy. Delays in transition or large divergences across countries could lead to higher economic and financial costs from both physical and transition risks.
To better understand the impact of climate-related physical and transition risks on the global banking sector as well as overall financial stability, we need to pay attention to climate physical and transition risk assessments.
Climate physical risk analyses aim to assess the impact of climate change on the economy and the banking sector for countries where physical risks are material. For example, rising global temperatures can cause extreme weather events of higher frequency and intensity and longer-term shifts in climate patterns. These hazards cause damages to physical assets, markets, and productivity that in turn can affect the resilience of the banking sector. For instance, in the IMF’s assessment of the financial sector (FSAP) for the Philippines, the climate physical risk analysis focused on the impact of typhoons. The analysis found that under the current likelihood of typhoons, extremely rare typhoons could result in a reduction in GDP of 5 percentage points in the case of a once-in-100-years typhoon, with larger reductions in GDP as the severity of the typhoon increases—up to 14 percentage points in the case of a once-in-500-years typhoon.
Climate transition risk analyses focus on assessing the impact of the policy reactions to climate change on the economy and the banking sector. The recent assessment of the financial sector for the UK conducted a climate transition risk analysis assessing the impact of pricing in up-front the change in companies’ prospects—due to shocks associated with technology and policy changes—on asset valuations. Ultimately these valuation losses translate into market and credit losses for banks. This analysis estimated that a transition to net zero generates credit losses of 3.6 percent on banks’ corporate loan portfolio and market losses of 4 percent on banks equity and corporate bond holdings, on average.
For supervisory authorities these analyses are extremely important, because preserving financial stability is their core mandate. Therefore, supervisors should ensure climate-related risks are adequately captured in their supervisory processes. This helps facilitate early intervention when climate risks are assessed to be material. Financial sector supervisors can take several actions in this regard. They can allocate adequate resources and build internal capacity for supervision of climate risks. In addition, they can provide guidelines for financial institutions on governance, management, and disclosure of climate risks. Finally, they can take steps to improve data collection from financial institutions to better monitor climate risks.
I would like to conclude by identifying two of the main priorities for the coming years.
First, developing a science-based, tailored, and consistent climate information architecture in emerging markets should be a prerequisite for the development of sustainable finance markets in emerging economies. It contributes to many of the objectives that are sought to effectively finance transition policies and manage risks stemming from climate change and other environmental concerns: the efficient pricing of climate risks, the fight against greenwashing practices, and the efficient allocation of capital towards transition and low-carbon projects.
Second, lifting the data constraint in emerging economies is a policy priority to effectively develop sustainable finance markets. A few emerging market economies have now developed mandatory requirements for climate-related disclosures for corporates. This is a step in the right direction, and company disclosures will definitely lead to an expansion of the policy and financial research analysis beyond pure “green” products.
It should go further, in a complementary fashion. For instance, adopting the forthcoming International Sustainability Standards Board’s sustainability and climate standards should be made mandatory across the world. It is a common baseline upon which countries can build better tailored and proportionate frameworks. In addition, to avoid any further fragmentation, and considering the common challenges faced by many economies, harmonization should be sought when issuing additional requirements to the ISSB baseline, at a minimum at the regional level. Developments within the ASEAN region, for instance, go into the right direction. And let us not forget that developing sustainable finance classifications, including taxonomies, is a helpful way to inform capital allocation towards transition and low-carbon projects, to build greater trust on sustainable finance markets, and to avoid information asymmetry. While Asia and South Africa have paved the way in this regard, and there is room for development in other areas of the world.
Momentum for all these initiatives is continuing to build, and there exist good opportunities to move forward toward implementation in a number of countries. By taking action now, we can better ensure a stronger foundation for sustainable finance in emerging markets in the years ahead.
*Tobias Adrian, Financial Counsellor and Director of the Monetary and Capital Markets Department, IMF. Presentation at the 7th Global Meeting of the Sustainable Banking and Finance Network