How Are Climate, Financial Inclusion & Financial Stability Linked?

In Lagos, a large Nigerian microfinance institution has started screening clients based on geography. If they live in parts of the city prone to flooding, instead of receiving a loan, they are advised to move to another area. 

Halfway around the world in California, the largest insurer in the United States has stopped offering property insurance across the entire state due to the increasing risk of wildfires. 

The two contexts could not be more different, but the phenomenon is the same: financial inclusion is receding due to climate change.   

In our interviews with financial authorities on climate change, this did not come up once across more than a dozen low- and middle-income countries. While many are actively developing strategies and regulations to manage climate risk and green the financial system, these center overwhelmingly on safeguarding financial stability. There is little consideration of the linkages to financial inclusion.

This may not be surprising, but it is cause for concern. Climate risk and financial exclusion are in fact intricately linked, with feedback loops running in both directions. The good news is this means that as financial authorities across the world develop their climate change responses, they have opportunities to create a virtuous cycle that both expands financial inclusion and reduces climate risk. But these opportunities could be missed if not actively explored. More worryingly, climate strategies that don’t consider the linkages could have unintentionally adverse effects that deepen financial exclusion and undermine resilience — including of the financial system itself. 

CGAP’s new working paper, Climate Risk and Financial Inclusion: A Regulatory Perspective on Risks and Opportunities, describes how the interplay between climate change and financial inclusion influences financial stability. The paper draws from economic literature, recent work from global standard-setting bodies, and the previously mentioned interviews with financial authorities. It outlines important considerations and suggested policy actions for these regulators as they continue developing their climate change strategies.

The links between climate risk and financial exclusion

Climate change and environmental degradation can affect financial inclusion in three distinct ways: through physical risk, transition risk, and unintended consequences.

1. Physical risk may drive financial services providers away from serving their most climate-exposed clients 

Extreme weather events such as droughts and floods as well as slow onset ones such as desertification damage assets and infrastructure, disrupt livelihoods, and create costs for recovery. Financial institutions respond to the resulting increased credit risk by reducing their exposure – in other words, reducing their financing – to those borrowers. Poor households and small businesses tend to not be very profitable customers in general. Now, they also find themselves particularly exposed to physical climate risk, so they will likely be the first customers to be affected as financial institutions withdraw, exacerbating financial exclusion and reducing climate resilience of poor households and small businesses. 

2. Transition risk may also drive the financial sector away, but for different reasons

The fast pace of green technology advances (and in some cases, short-sighted decision-making) means that business investments in older technology may not pay off, leading to stranded assets. Financial institutions have an incentive to reduce their exposure to those relying on older technologies such as non-renewable energy, due to both reputational and liability risks. The shift away from polluting sectors is welcome and vital, but it must be recognized that poor clients have greater difficulty financing their shift to some low-carbon technologies – whether this is the upfront cost of new technology deployed at the business or household level, or as consumers of technology deployed by an energy utility. A truly just climate transition needs to address poor clients’ role as consumers of energy and transport services, not just as workers in high-carbon sectors.  Without appropriate policy measures in place, the transition could increase inequality and lead to unjust outcomes.  

3. Climate-related financial regulations may have unintended exclusionary effects

For instance, new reporting and disclosure requirements are important for seeing and acting on climate risk exposure, but they also impose new costs. If applied without discrimination, such transaction costs will erode the already meager business case for serving low-income clients. 

The bottom line is simple: regulation is needed to mitigate the climate risk facing financial institutions, but it should be carefully designed to minimize exclusionary effects.  If it is not, climate risk, financial instability, and financial exclusion could cause spiraling vulnerability. This is because clients that suffer reduced access to financial services due to climate risk are left with fewer tools to manage that risk. Since even poor clients are also consumers, this in turn may exacerbate the climate vulnerability of the real economy, with repercussions for financial stability. So even those who are only concerned about financial stability ought to pay attention to the links between climate, financial inclusion, and the real economy. 

The way forward: A virtuous cycle

On the other hand, inclusive climate regulation can drive a virtuous cycle of growing resilience and financial stability (see illustration below). If those at the margins of the financial system can afford to insure themselves against shocks, invest in green technology, and adapt to climate change, they will increase their resilience.  A more resilient economy in turn reduces the risks facing the financial sector, enhancing stability. 

A virtuous cycle of green resilience and supporting policies

Over the next few months, CGAP will further explore the potential unintended consequences of climate-related financial sector policies, and potential solutions. Let us know in the comments below if you have seen unintended exclusionary effects or good examples of inclusive climate regulation in your country or reach out to us to further discuss our work at cgap@worldbank.org.