New data add perspectives on climate-related financial risks in Malaysia, and how financial institutions should react

  • The misalignment of financial institutions’ portfolios on climate transition raises the importance of taking a holistic perspective on direct & indirect transition risks as well as physical risks
  • It is important to remember when selecting climate scenarios that each one represents an ethical choice that weights present and future generations differently

Financial institutions in Islamic markets are increasingly focused on climate-related financial risks. Measures to analyze these risks continue to develop, providing an important portfolio of evidence that was added to recently with a report released by the 2 Degree Investing Institute (2DII) together with WWF Malaysia on the transition risk facing Malaysian banks. The research complements other efforts to focus on the climate-related risks facing Malaysian financial institutions including physical risks, which Bank Negara Malaysia previously estimated could impact almost 12% of Malaysian financial institutions’ assets, and RFI Foundation’s previous estimates of financed emissions throughout Malaysia showing how interconnected direct and indirect financed emissions risks are across the financial system.

The latest analysis consolidated a pilot study by eight Malaysian financial institutions, which each used the 2DII PACTA tool for climate alignment of high-carbon sectors to look at the degree to which Malaysia’s financial sector was in alignment with — or misaligned with — long-term climate scenarios including current policy commitments on climate change, the Paris Agreement’s 2° C target, or the more ambitious IEA Net Zero by 2050 scenario that limits warming to 1.5° C through 2100.

The PACTA analysis found significant misalignment from either the 2° C temperature rise Sustainable Development Scenario and also the 1.5° C scenario for Net Zero by 2050. The degree of misalignment varied across different high-carbon sectors such as oil & gas, power generation and automotive, as well as showing some undershoot compared to necessary targets relating to low-carbon sectors such as renewable energy.

The report also highlighted the importance of a just transition to a low-carbon economy, which will inform the policy and financing decisions to be made over the coming years. It notes that “the challenge is to ensure that the low carbon transition does not only contribute to climate goals but also addresses issues of inequities and justice for affected communities. Hence, a just transition strategy is essential in the formulation of plans to address resistance against the climate transition.”

One of the key challenges in responding to climate change from the financial institution perspective is that over their relevant time frame for acting, between three and five years, it can appear there is a trade-off between physical and transition risks, and there is a trade-off between the two. However, it is not a trade-off that is evenly balanced, and treating it as such dramatically oversimplifies the challenge facing financial institutions.

Financial institutions have to look at this from three different perspectives, corresponding to the:

  1. transition risks relating to the sectors most directly impacted by the transition process from high-carbon status quo to the low-carbon future that is needed to achieve the Paris Agreement or Net Zero objectives; and
  2. transition risks relating to the spill-over of impacts from rapid changes, or a lag in progress in transition, by the high emitting sectors in the process of shifting to low-carbon sectors.

In this respect, the approach of 2DII-WWF is strongly complementary with the RFI Foundation’s analysis. The former focuses mostly on the trajectory over a 5-year time horizon on risks described in point (2). The PACTA methodology, although it looks into the future, does so from a static perspective in terms of a bank’s loan book. From an individual bank’s perspective, one way to improve its alignment with the climate scenarios is to reduce financing to those sectors and expand financing in other sectors, preferably those that contribute to the transition.

However a divestment-oriented strategy in isolation may not achieve the needed transition if the high-carbon assets are financed by a different financial institution that has a lower ambition on climate change. If the transition risk is merely moved around within the financial sector, it may reduce direct sources of transition risks for a bank, but some of that risk will remain embedded indirectly in the assets they finance.

This is where the RFI Foundation’s report provides complementary data to build on what was found in the PACTA assessments. RFI’s report highlights the susceptibility of financial institutions and other financial assets in the economy to spill-over between the main direct sources of emission (subject to the highest transition risk) and other sectors of the economy.

Financial institutions will be directly impacted by the high-carbon sectors’ transition risk when carbon prices rise domestically, or are imported through carbon border adjustment tariffs. The key mechanism for direct risks divested manifesting through indirect risk exposure comes because high-carbon sectors in the PACTA analysis such as power generation (electricity) and automotive (transportation) are important inputs, while the externalities of a linear economy (waste management) are also sources of risk across the economy.

Finally, stepping back for a wider perspective in thinking of scenarios that could describe future physical or transition risks, there is an implicit, intergenerational trade-off built into the climate scenario assessments that are selected. RFI noted in a comment in June 2020 in response to Bank Negara Malaysia’s consultation on the Climate Change and Principles-based Taxonomy that interest-based metrics are generally inappropriate for making choices where the implications are sufficiently long-term.

This adds to the perspective around the just transition quoted above, and carries particular relevance in Malaysia, where 30% of banking sector assets are held by Islamic banks. However, it is a concern for all financial institutions and policymakers, not only those offering Islamic financial services. The concerns that we raised relied upon economists such as Martin Weitzman and Christian Gollier, who brought a conventional economics perspective and took issue with using interest rates to balance current and future generations’ interest in the impacts of climate change today long into the future.

It should leave us with a valuable principle when devising different near-term metrics of climate risk, that “there is no deep reason of principle that allows us to extrapolate past rates of return on capital into the distant future [and] there is an ethical dimension to discounting climate change across many future generations that is difficult to evaluate and incorporate into standard [cost-benefit analysis which] has critically important implications for climate change policy”.

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Blake Goud

Blake Goud

Promoting adoption of responsible finance in Islamic markets & Islamic finance. CEO @RFIFoundation.