Will climate data be widely available across Islamic markets?

• The IPCC report presents a stark view of the physical risks that have now become inevitable, and financial institutions need to be prepared
• The climate data needed for financial institutions to prepare may not be widely available for institutions of all sizes, especially in emerging and developing markets
• Malaysia’s Joint Committee on Climate Change (JC3) can serve as a good example of proactive efforts to improve financial institutions’ access to data and an understanding of how to leverage it to manage climate risks

The news from the newest IPCC climate report is alarming whether or not you’ve been following the issue closely. The impact of climate change under every likely scenario from where we find ourselves today will bring a continuation of the dramatic heatwaves, drought, forest fires and floods that have become increasingly common in the past few years.

This much is certain: these are no longer outlier events. They will become more the norm, meaning that the most pressing visible climate-related impact will come from these physical impacts. This will be especially felt by insurers and takaful operators, and it will make trends in financial inclusion that help those most vulnerable to climate change through insurance more difficult to achieve.

However, the locking in of the serious climate-related physical risks that the IPCC report highlights may not even become the most significant source of risk for financial institutions. The IPCC report sheds, if not a hopeful light, then one that cautions us away from climate fatalism. It shows how much of the severity of future impacts of climate change depend on the near-term changes that are being made to affect the trajectory of greenhouse gas (GHG) emissions related to human activity.

The IPCC report concludes two critical points:

“[1] Global surface temperature will continue to increase until at least the mid-century under all emissions scenarios considered. [2] Global warming of 1.5°C and 2°C will be exceeded during the 21st century unless deep reductions in CO₂ and other greenhouse gas emissions occur in the coming decades.”

Financial institutions already have to manage the impact of physical risk in their risk management processes and make investments to access and integrate climate data (for example, relating to spatial risk analysis). At the same time, they need to understand that physical risk is not the only dimension of climate impacts they will face. Transition risk — which could be disorderly or become a more severe risk if countries pursue an uncoordinated push towards Net Zero — will come together with physical risk outcomes in shaping how national policies, regulations and targets are set and updated.

These national targets and regulations may have some local effects that are endogenous based on the degree to which physical impact is manifesting in ways that are felt locally. The cost of higher exposure to physical risk will be felt directly by financial institutions, but may also have a feedback loop that generates higher policy transition risk at the same time. This interrelationship between physical and transition risk raises the risk and embedded cost of inaction by financial institutions.

On the flip side, investment in capacity to measure and track climate-related risks will become even more valuable for financial institutions to help them avoid the reinforcing impact of physical risk realization and resulting regulatory transition risks. For many financial institutions in Islamic markets (and other emerging and developing markets) there will be uneven and suboptimal deployment of the new risk management capacity by financial institutions. Many may be priced out of the market for the latest climate risk data and analytical tools, or may not be able to invest enough in their internal capacity to use these tools.

This sets up further risks to financial stability that were already remarked on by the Financial Stability Board last year. The FSB pointed out that developed market-based banks would have diversification from cross-border lending into emerging and developing markets. However, flows to those markets will have exaggerated cyclicality in response to climate risk materializing.

It is problematic if cross-border financial flows from international financial institutions improve their diversification against climate-related risks even as individual recipient countries experience heightened financial stability risk from the impacts of climate change. In order to promote equitable climate outcomes, it will be critical to improve the ability of emerging & developing market financial institutions to access and use new climate risk data, spatial data on assets, and analytical capabilities.

In the absence of international assistance to promote climate readiness, it will be much harder for domestic and regional financial institutions in emerging & developing economies to avoid adverse climate-related selection. In the absence of balancing out access to climate data, the more data-rich international financial institutions will be able to cherry pick less climate-exposed customers while leaving a more risky universe of customers for domestic financial institutions.

The data will drive pricing advantages for the financial institutions with access to it in comparison to smaller institutions, who will find it harder to avoid offering rates too high to compete with international institutions for the business of less climate-risky borrowers and who will price financing too low to account fully for the climate-related risks of more exposed customers.

Regulators are working together to help solve the problem of data access for at the regulatory level by creating and disseminating forward-looking scenario baselines for regulators and financial institutions to use as a common ground through the Network for Greening the Financial System. There have been fewer efforts to get the banks to collaborate to address the problem of inequitable access to data and analytics that may impact financial stability in many Islamic markets.

One example where action to bridge the data gap is progressing is in Malaysia, where a regulatory effort jointly organized by banking/insurance and securities regulators and the financial institutions, the Joint Committee on Climate Change (JC3), has formed a committee working to bridge the data gaps by collecting climate data available to the financial sector for “data to support investment and lending decisions, macroeconomic modelling, stress testing, scenario analysis and product development”. Another committee established under the same program is developing guides to help financial institutions with scenario analysis.

We are at a critical moment where the impact of amplifying and replicating these types of efforts to increases both data access and capacity development will have an outsized impact on future emissions. If some of the international aid supporting climate action by developing and emerging markets is focused on helping more financial institutions to access and use the data and tools that are being developed, more institutions will be able to help steer the world towards Net Zero and increase the chances of reaching it by 2050.

The IPCC report is clear: many of the rises in climate risk are baked in already. However, the extent to which the worst outcomes and disorderly transitions will occur are still going to be determined by the speed of action and the breadth of that action across economies and in financial institutions around the world. It is too important a challenge to leave behind financial institutions simply because they are smaller, more domestically focused, or are in emerging or developing countries.

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