In this first part of a two-part interview, Arup Chatterjee, Principal Financial Sector Specialist, Sustainable Development and Climate Change Department at the Asian Development Bank, speaks with Siddharth Poddar and Shivaji Bagchi of Unravel about how growing climate-related risks will impact infrastructure in the region. He also speaks about the impacts on financial market stakeholders – both from the public and the private sector.
Unravel: The recent UNEP IPCC report presents some damning facts. It says unequivocally that humans have caused climate change, driven up greenhouse gas emissions, and contributed to warmer weather – and many of these changes are irreversible. What do you think will be the economic costs and financial impacts of these changes in the future?
Arup Chatterjee: The IPCC’s messages make a solemn read. They sound the alarm about the possibility that climate change has driven our planet dangerously close to the tipping point and poses significant risks to both developed and emerging markets.
According to Swiss Re Institute estimates, if unchecked, climate change could shave 18% off the world GDP by 2048. Asian economies will be hit the hardest due to their inherent exposure to pollution, biodiversity loss and climate hazards like rising sea levels, flooding, droughts, severe typhoons, extreme precipitation, storm surges and lethal heatwaves.
Moreover, it will take a toll on critical sectors such as agriculture, tourism and fishing, and adversely impact human health and labour productivity.
It will also negatively impact financial institutions as they actively exacerbate those risks by providing substantial financing to activities intensifying climate change. It can lead to destabilising losses for banks, insurance companies and other financial services providers with direct and indirect exposure to different affected sectors and assets. On average, the Asian region could lose up to 26.5% of GDP by the middle of the century.
Unravel: It is expected that extreme weather events will worsen, and many studies expect such events to be more frequent in Asia. Is the region investing sufficiently in climate-resilient and sustainable infrastructure?
Mr Chatterjee: The Asian region was vulnerable to extreme weather events even before climate change became a mainstream issue. However, global warming is likely to trigger more frequent and severe weather disasters, owing to changes in rainfall patterns, droughts, rising sea levels and typhoons. And Asian countries are expected to bear the strain of this shift.
Extreme climatic events are likely to stress critical infrastructures. The most significant risk is that infrastructure isn’t up to the task of handling extreme climate change-influenced weather events. Vulnerability to climate variability threatens to dent one of the key aspects of infrastructure—its long lifespan. Infrastructure—such as dams, embankments, bridges and ports designed for 20th century climate—is not resilient to withstand today’s climate disasters. As a result, it will impact the reliability and efficiency of energy, transport and water networks.
In rural areas, particularly in low-income countries, roads and irrigation systems are critical for livelihood. In addition, climate change impacts these networks in terms of maintenance, repairs, and durability as a usable infrastructure.
The Asian Development Bank, in 2017, estimated a financing gap in the economic infrastructure of $459 billion per year for Asia. The current and predicted infrastructure shortfall will be exacerbated further by climate change.
Investments in sustainable and resilient infrastructure as a response could offer significant opportunities for projects and enhance the quality of life.
Multilateral development banks are key actors in the challenge of moving from billions to trillions by crowding in private sector finance necessary to fill the infrastructure funding gap. Besides integrating climate adaptation into projects, they have operationalised a climate risk management framework in the investment project cycle.
The disaster risk reduction investments extend beyond physical infrastructure to include financial resilience, eco-based resilience, and social and institutional resilience. The adoption of a holistic resilience approach aims to build resilience in the face of a wide range of shocks and stresses. It ranges from structural financing projects to nature or eco-based solutions, community-based resilience infrastructure and projects that combine non-structural interventions like early-warning interventions.
Such an approach ensures economic benefits and builds resilience at all levels – individuals, households, communities, businesses and countries.
Unravel: How are these climate risks impacting financial market stakeholders and what responses are they considering to mitigate them?
Mr Chatterjee: Today, climate change is viewed as a systemic risk and can result in serious negative consequences for the real economy.
Two categories of climate-related risks are likely to impact the financial sector and financial stability adversely.
The first comprises physical risks associated with more frequent severe weather events and lasting environmental changes that directly affect people and assets. These can leave insurance companies vulnerable to large-scale unforeseen losses and increase premium rates in the future.
Moreover, it could lead to disruptions in the supply chain and erode asset values in disaster-prone areas, thus affecting collaterals pledged with the lenders. It will also adversely impact borrowers’ solvency since a collapse of local economic activity can adversely affect livelihoods and incomes.
Therefore, higher-than-expected losses are likely to affect the bottom-line of banks and insurance companies adversely.
The second category comprises the transition risks posed by the economic, policy, technological and social changes for mitigating climate change and achieving a net-zero carbon economy. If the transition from carbon and water-intense economies is unmanaged, it can result in volatilities in revenue projections due to stranded assets, adverse movements in asset prices, credit risks and labour market frictions. These risks take several forms, from fossil fuels to renewables, from internal combustion engines to battery and electric vehicles, carbon taxation for disincentivising greenhouse gas emissions, policies aimed at incentivising changes in land-use and farming practices, and legal risk arising from compensation claimed by investors due to lack of non-disclosure of climate risks from businesses.
All these risks can affect the balance sheets of banks and insurance companies because of the high degree of uncertainty about the transition’s trajectory and the material effect on their portfolios due to the equity and fixed income assets held by them. Therefore, responding to these risks warrants heightened scrutiny from financial market stakeholders—regulators, governments, central banks and supervisors, financial market participants, firms, and even households—to enhance the resilience of assets and communities.
While the current discourse around climate change and transition risks focuses on negative impacts, enhanced adaptation and mitigation efforts offer myriad opportunities for some businesses.
John Maynard Keynes’s quote is apt here: “When I find new information, I change my mind; what do you do?” So, for example, businesses can profit by positioning themselves to benefit from low carbon tailwinds and avoiding high carbon headwinds, using resource efficiency and cost savings, adopting low-emission energy sources, developing new products and services, accessing new markets, and building new markets resilience along the supply chain.
Unravel: What about the policy and regulatory responses of governments?
Mr Chatterjee: Policy and regulatory responses need to keep climate-related risks in the backdrop.
For governments, these risks pose a substantial threat to financial stability via direct fiscal impacts, increased cost of borrowing, or triggered contingent liabilities. Moreover, the International Monetary Fund’s inclusion of climate-related financial stability risks in its financial sector surveillance will put more onus on national governments to walk the talk.
Governments are exploring micro-fiscal risk assessments, enhanced with climate-related vulnerability risk analysis to identify system-level risks before considering coordinated policy and regulatory actions.
These include the factoring of contingent liabilities arising from climate-related risks in their fiscal planning and budget process. Additionally, the design of sustainable finance roadmaps is being encouraged to mobilise private sector finance, aligned with long-term strategies.
For climate-related physical risks, governments are using budgetary instruments like contingency funds and credit lines. And, where appropriate, they are considering developing sovereign risk transfer instruments like insurance, reinsurance, catastrophe risk bonds, and establishing national and regional risk pools to enable quick recovery.
Green stimulus and supportive policies can ensure diversifying the economy away from climate-sensitive economic activities. Among the options on the table for mainstreaming climate considerations into the design of public policies are green fiscal reforms for supporting the implementation of a long-term transition strategy at the national level. Green budgeting is also viewed as a powerful tool to monitor progress and ensure climate policy coherence.
Governments are also engaging in the greening of state-owned enterprises by exercising their fiduciary role. By reducing the carbon footprint, they can mitigate the contingent liability of transition risks. Such measures also help create positive spillovers for the low-carbon transition by signalling private companies in the same sector to follow suit.
And, financial regulators are considering assessing how financial firms manage climate-related risks and taking actions to bolster the financial system’s resiliency. They have started by engaging in awareness-raising of climate risks and developing a more consistent taxonomy for green investment products such as green and sustainability bonds and carbon market instruments. Some have surveyed the financial institutions they supervise to understand how they manage climate risk and how to incorporate climate-related risks into their business models and risk assessments in a better manner. Also, some authorities have announced supervisory expectations by specifying the key elements that must form part of financial institutions’ disclosure about the prudential management of climate-related risks to help quantify climate risk in banks and insurance companies’ portfolios and balance sheets. These elements take into account aspects like governance, strategy, scenario analysis and risk management. Additionally, some have carried out climate risk stress tests for major banks and insurers that include a 30-year time horizon.
Not to mention, development finance institutions support green transition with innovative financial instruments by combining grants, soft loans, technical assistance, guarantees, and equity for adaptation financing.
However, the onus doesn’t solely rest on the governments to deliver on the lofty climate goals. Instead, the private sector must actively engage in bolstering governments’ commitments with tangible actions.
By collectively pursuing action to avoid the most catastrophic impacts, the public and private sectors can seize the opportunity to tackle climate change.
* The views expressed are personal.