To address these issues, banking authorities are beginning to adopt novel approaches to manage climate-related financial risks and enable climate finance.
Some progress to date has been made through several EMDE banking authorities’ innovative approaches to addressing climate risk. For example, central banks in Morocco, the Philippines and Mexico have been customizing their climate risk assessments to local extreme weather patterns involving droughts, floods, and typhoons. But much work remains to be done. A particular challenge for EMDE banking authorities is how to enable more climate finance without compromising their primary financial stability objectives, while also continuing to support financial inclusion for underserved groups.
Most of the tools used by EMDEs to support climate financing are relatively new and empirical evidence about their suitability and effectiveness is still emerging. And of course, new tools will continue to be developed and tested.
Based on experience to date, the effectiveness of regulatory tools can broadly be divided into three categories: first, ‘win-win’ tools that support both financial stability and climate finance objectives, if adequately designed; second, tools that have the potential to enable climate finance, but for which ‘the jury’s still out’ until there is enough evidence to establish their suitability; and finally, tools that are ‘not recommended’ because they lack a proven record when it comes to mobilizing finance and also have a higher likelihood of compromising financial stability.
For example, transition planning (a win-win tool) is a promising measure in the prudential toolbox that can help banking authorities and investors better understand how a bank plans to align its operations with climate regulations and take advantage of green opportunities. The Philippines and Singapore have already started down this path.
There is growing interest among central banks in using so-called targeted refinancing operations—providing more favorable financing terms for climate friendly lending by banks—to encourage green finance. The Central Bank of Egypt operates various green credit facilities along these lines for farmers and renewable energy. The People’s Bank of China launched a carbon emission reduction facility that provides lower-cost funding for banks that on-lend to selected green sectors. Yet because this method could have distortionary impacts on financial stability, the jury is still out on it.
And credit allocation policies have been used to attempt to steer financial flows to green sectors or projects. The central banks of India and Bangladesh set quantitative targets for the share of a bank’s portfolio to be allocated this way. Yet prioritizing lending targets over risk management has had mixed success when previously deployed for targets such as small business financing, and it can create moral hazards and other risks. Consequently, green credit targeting is not recommended.
Emerging applications of tools to manage risk and enable climate finance
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