A new Forecast Policy Scenario should inspire robust climate risk measurement by financial institutions in emerging & developing countries

• The effects of the Paris Agreement ratchet have been the upgrading of nationally determined contributions and new Net Zero targets
• Policies to drive implementation towards these longer-term goals will impose a cost on emitted greenhouse gases in line with their social and environmental impacts that will cause the twin shocks for emerging & developing countries of domestic policy risk to meet climate goals and trade-related carbon tariffs introduced by trade partners
• Financial institutions in emerging & developing countries will face increased risk and should be preparing now for how they plan to track, measure and mitigate the risks and comply with future disclosure requirements from regulators and investors

The Inevitable Policy Response, an initiative of the Principles for Responsible Investment, has released its updated forecast policy and required policy scenarios on climate change. The result is alarming for emerging and developing countries, which account for a large proportion of Islamic markets, as they will face both higher physical risk and greater risk relating to adjusting to the impact of policies needed to close the gap and limit climate change to 1.5°C.

The policy forecasts from IPR are developed based on the operation of the ratchet mechanism contained in the Paris Agreement to encourage increasing ambition over time as we approach 2030. The workings of the mechanism can be seen in the latest round of commitments by countries to strengthen their emissions reduction and renewable energy targets from their original nationally determined contributions, and to make commitments to Net Zero by mid-century.

These national commitments on their own don’t cause emissions reductions, and they won’t be the source of changes to shift energy systems towards decarbonization. Instead, they frame the parameters that will guide other policy-making at the national level and below that will affect the whole economy. The policies implemented and the timeframe over which they will be adopted and implemented will vary between countries, reflecting the ‘bottom-up’ nature of the Paris Agreement.

The key to understanding the influence of policies at the national and international level from the perspective of investors and financial institutions is by evaluating how higher costs for greenhouse gas (GHG) emissions affect their investments or financing. The RFI Foundation has highlighted this approach in our financed emissions reports tracing the financing of direct and indirect emissions through the financial sector’s exposures.

Viewing the impact of policies on finance and investment through pricing of GHG emissions doesn’t mean that financial institutions wait until an explicit carbon tax is adopted that affects their customers. It means instead recognizing that all of the policies to limit emissions are in effect making these emissions cost more through a range of policy changes.

For example, the IPR’s forecast policy scenario includes a rise in electric vehicles on the road to 30% of the total. Technological change — such as better, lower-cost batteries — will affect the competitiveness of EVs compared to internal combustion engines (ICE), but incentives or subsidies for purchases will also lower the cost of EV (and increase the relative costs of ICE vehicles). Varying congestion pricing regimes in urban areas may also tilt the balance by raising fees more for ICE than for EV.

Other policy decisions will change the accessibility of EVs more indirectly. For example, OJK in Indonesia relaxed risk calculations for banks when they finance EVs or companies involved in their manufacturing process. This capital-easing measure may provide a pass-through effect on the financing cost that banks can offer to consumers for EVs and also affects the cost structure within the manufacturing value chain.

None of these examples rely on carbon taxes or the use of voluntary carbon markets, each of which are also usable in an ‘all-of-the-above’ response to climate change. The examples in the preceding section still result in expectation that the environmental and social costs resulting from greenhouse gas emissions should be considered as a real economic cost when evaluating future creditworthiness or investment potential. That’s how the IPR report’s findings should signal alarm bells in every country’s financial sector, but particularly in emerging & developing countries.

The IPR’s forecast policy scenario anticipates that OECD countries will reach net zero by 2050 (but says they should still do more to reach the required policy scenario). Non-OECD countries reduce emissions considerably under the forecast policy scenario (by about two-thirds of current levels by 2050). However, there is a considerable gap between the forecast and required policy scenario to stay on target for achieving the 1.5° C target needed to avoid some of the worst physical impacts, which disproportionately affects emerging & developing countries.

In the more immediate term, many of the policies highlighted in the forecast policy scenario show a wider gap in emerging & developing countries than in developed countries with the required policy scenario for a 1.5° C future. These include policies to:

• phase out unabated coal power
• reach 100% clean power
• phase out fossil fuel vehicles (including heavy vehicles), and
• phase out fossil fuel heating systems.

The wider gap between forecast and required policies in emerging & developing markets means they will be subject to more financial risks from policy tightening than developed markets. Their exporters, meanwhile, will be more at risk from the spillover of policy tightening in developed markets through policies such as the EU’s carbon border adjustment tax.

For financial institutions or investors based in emerging & developing markets, these latest policy forecasts should inspire deeper analysis into how they are evaluating these risks to their outstanding financing & investments today, next year, and throughout their intermediate strategy planning period.

For many banks in developed, emerging and developing countries, the level of preparation falls significantly behind where it could be and where regulators have been signaling they will expect it to be in the near future. For evidence, the Network for Greening the Financial System released a paper analyzing how, where and when central banks and other regulators from a wide range of countries are using scenario analysis in their climate-related financial risk surveillance.

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