Finding a ‘win-win-win’ outcome for decarbonization and economic growth from stronger climate policies

There is a win–win-win potential for policies to strengthen climate mitigation efforts in emerging and developing countries. New research provides evidence that stronger climate policy can induce more financing from foreign banks seeking green investment without reducing other financing channels. Increasing investment towards decarbonization is also the best way to mitigate long-term risks from climate change that could threaten financial stability.

• Climate mitigation requires up-front, capital-intensive investment, and expanding access to financing has been a key priority in promoting decarbonization
• Conventional wisdom suggests that stronger climate policy could move in parallel with monetary tightening to restrict financing at a time when it is needed more than ever
• A new research paper from the World Bank finds that stronger climate policy increases financing by local branches of foreign banks with strong environmental risk practices without reducing financing from other sources

One of the hopes in responsible finance is that policy that improves the financial sector’s recognition and management of climate risks will create positive spillover to the economy as a whole. This is particularly a concern as regards to emerging markets & developing economies, which are concerned about climate vulnerability and the risk that climate mitigation can be difficult if it represents a ‘trade-off’ against economic growth.

A new World Bank policy research paper suggests that rather than forcing such a ‘trade-off’, stronger climate mitigation policy may lead to a ‘win-win’ outcome that increases short-term financing from local branches of foreign banks with good environmental risk management policies without causing a reduction in finance by other banks (either foreign or domestic).

The challenge of climate mitigation is that the transition from fossil fuel to clean energy requires more up-front investment than does taking no action. This has become a concern of policymakers fearful that monetary tightening will slow investment in decarbonization. In response to these concerns, the ECB’s Isabel Schnabel recently reiterated that fiscal policy was still in the driver’s seat on decarbonization policies and monetary tightening shouldn’t be used as an excuse to delay decarbonization.

However, when other policy is evaluated for its ability to drive investment in decarbonization, there remains a question about the ability to sustain the needed investment over time. On the one hand, stronger climate policy could be viewed as a cause of slower investment at a time when monetary policy is also leading to tighter financial conditions. On the other hand, delaying decarbonization is impossible because of the rising risks to inaction that threaten severe economic consequences, particularly for emerging markets & developing economies.

And that’s where the new paper from World Bank researchers comes in. They focus their investigation on the interaction between domestic climate policy and the lending of local branches of foreign banks. Foreign banks often provide a conduit for foreign investment, and also operate in global banking companies where they can change their prioritization of different markets in response to changing opportunities and changing policy. In turn, this potentially makes them greater sources of either expansion or contraction of financing in response to policy changes.

If they respond to stronger climate policy by reducing financing in the markets where policy is strengthened, this could provide a limit on the speed at which policy changes to avoid too much economic disruption. However, the impact found in practice was the opposite — when countries strengthened their resolve on climate, through new policies or stronger implementation of existing policies, the net effect was more financing from domestic branches of foreign banks.

Furthermore, the impact was strongest among foreign banks with better environmental risk practices, whose lending increased 4.6% for each increment of stronger climate policy. Those banks also increased their employee numbers by 4% for every increment of stronger climate policy. At the same time, foreign banks with weaker environmental risk management didn’t reduce their lending and the domestic banking sector (which is more sensitive to interest rates and local economic conditions) was unaffected.

This result should offer comfort to policymakers considering stronger climate policy because it presents policy strengthening as a ‘win-win’ as far as maintaining access to finance for the domestic economy. The authors suggest it shows that foreign banks with stronger environmental risk management expand their lending activity on balance in pursuit of green assets while other banks remain unaffected by stronger climate policy.

This also provides a way for emerging markets and developing economies to mitigate their longer-term climate risk through stronger climate policy now. The sample of banks included in the research included about 40% developing country-based local branches of foreign banks. These emerging markets and developing economies are most likely to be vulnerable to either an exit of foreign banks in response to realization of climate risks, or an exit of insurers from climate-vulnerable countries whose insurance cover is often key to foreign banks maintaining long-term financing.

Putting these conclusions together, the longer-term risks in emerging markets and developing economies from climate change remain substantial and rising with delayed decarbonization. In the short-term, their strengthening of the climate policy response could increase lending by some banks without reducing the overall amount of financing available. And the acceleration of investment in climate mitigation in the short-term is critical to mitigating future risks to the financial sector in the long-run, providing a win-win-win outcome for foreign banks, domestic banks and the overall climate risk vulnerability of the financial system.

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