In an Era of Urgent Climate Risk, Does Financial Inclusion Matter?

World Environment Day 2022 will be hosted by Sweden on June 5 — 50 years after the Stockholm Conference that first designated this day to galvanize action on one of the most urgent challenges of our time: climate change. This year’s theme — “Only One Earth” — reminds us that this planet is humanity’s only home, with finite resources that we must safeguard. Much has changed since the Stockholm Conference of 1972, including the increasing interconnectedness of humanity. The last two years have been a stark reminder that we truly are “Only One Earth”: Viruses and wars do not stop at borders — and neither do carbon emissions or environmental disasters.

Poor people suffer disproportionately from climate shocks

Poor people in developing countries contribute relatively little to carbon emissions, yet they suffer disproportionately from the impacts of climate change compared to people in wealthy countries. Rich economies are responsible for more than 92% of historic excess global emissions, and the richest 1 percent of people today produce more than double the emissions of the poorest 50% of humanity. But our focus in this Essay note is not on who pollutes, but rather on who suffers from the impact of climate change. Indeed, we cannot just look at the climate hazard itself, nor just at its causes: as the Intergovernmental Panel on Climate Change has noted, we must also recognize who is being affected and the factors that make different people vulnerable.

Low-income communities are already being hit the hardest. Climate change manifests in first-order effects such as extreme heat and more intense and frequent weather-related natural disasters, leading to deaths, injuries, and the destruction of property.  Major climate-related shocks like flooding, droughts, and storms result in 15 times higher death tolls (IPCC 2022) in highly vulnerable countries compared to the least vulnerable countries. Yet climate disasters produce even more destruction through second- and third-order effects such as disease, malnutrition, displacement, conflict, and loss of livelihoods. Because poor countries do not have adequate public health, institutions, and infrastructure to contain the damage, these second- and third-order effects further accentuate the gap in climate impacts between the rich and poor.

Women and girls suffer more than men and boys. Women make up 80% of people forcibly displaced by climate-related disasters in developing countries, and they are more likely to die as a result of natural disasters like droughts, floods, and storms (IPCC 2022). Women and girls also experience larger second- and third-order effects, including increased risks of gender-based violence, dropping out of school, and early child marriage. Similar inequalities beset other marginalized groups, including the very young, the elderly, ethnic and religious minorities, indigenous people, and refugees (IPCC 2022).

While the poor suffer disproportionately, they have the smallest margins and least access to resilience strategies that can help them avoid, absorb, and adapt to shocks. Losses and damages are concentrated among the poorest vulnerable populations, as the intersection of inequality and poverty presents significant limits to adaptation responses (IPCC 2022). Moreover, any given loss affects poor and marginalized people far more because their livelihoods depend on fewer assets; their consumption is closer to subsistence levels; they cannot rely on savings to smooth the impacts; their health and education are at greater risk; and they may need more time to recover. Estimates of the impacts of climate change on the incomes of the poor found that, across 92 developing countries, the poorest 40% of the population experienced losses that were 70% greater than the losses of people with average wealth.

These stark inequities will surely grow worse as existing vulnerabilities and inequalities deteriorate further due to the effects of climate change (IPCC 2022). It is vital therefore that any development agenda, including financial inclusion, considers how poor and vulnerable households can build resilience and adapt to the climatic changes impacting their lives.  Without taking into account the impact of climate change on the poor and vulnerable, no development initiative will be sustainable.

In November, the United Nations will convene COP 27 in Egypt. The COP’s presence in Africa will highlight the necessity of focusing on adaptation alongside mitigation, and on including poor and vulnerable communities and countries in climate-change discussions. The conversation cannot just be about the poor and vulnerable: It must involve them to ensure it addresses their needs. That is not just the right thing to do, it is essential to ensure an inclusive and sustainable future for all.

Financial inclusion can help the poor build resilience to climate shocks 

The current focus of the climate change debate, understandably, focuses on macro-level challenges, with a strong emphasis on mitigation. When it comes to financial services, the discussions largely focus on the greening of the financial sector and on ensuring financial stability during the transition to low-carbon economies. Climate Fintechs attracted $1.2 billion in investments last year, and they are developing innovative solutions around carbon offsetting, carbon accounting, and supply-chain analytics. These initiatives are essential.

Yet the challenge of climate cannot be solved by focusing on only one side of the equation.  It is high time to also focus on the adaptation needed by the poor, and on how financial services can be used by the poor and the vulnerable, especially women, to help them build resilience and adapt to the many challenges — and opportunities — posed by the climate crisis. When it comes to building resilience to climate shocks at the individual and household level, it is essential to consider the role of financial services and how to translate the macro-level climate finance commitments into products and services that can help vulnerable households. It is also important to ensure that efforts to green the financial sector do not come at the expense of inclusive finance products that can help the poor build resilience and improve their livelihoods, including in the face of climate change.

Access to a range of generic financial services already helps build resilience. Reliable savings and remittance products, for example, do not need to be specifically designed for climate risks to help smooth consumption during periods of drought or to help speed recovery after a climate shock. However, other types of products can have a greater impact if they are specifically designed for certain risks. Credit products, for example, can help the poor invest in risk-reduction measures like irrigation, hardier seed varieties, or the transition into new livelihoods and diversified sources of income. Insurance helps poor people handle losses and helps them rebuild lives and livelihoods — and it also helps them become more resilient to the next shock. Adaptive social-protection payments from governments and humanitarian organizations help people survive the immediate aftermath of a climate shock — especially severe and large-scale shocks that vulnerable populations cannot manage on their own. The figure below depicts how different financial solutions are suited to different risks depending on likelihood and severity.

There are already many examples of financial products that have helped the poor manage climate shocks. During the January 2013 flooding in Mozambique, for example, people in affected areas used their mobile wallets to receive digital money transfers from friends and families. The velocity of these transfers was far greater than that of social-safety-net transfers from the government, or support from informal lenders.

Mobile money enables an informal insurance network that can effectively mitigate against the impact of both individual and macro shocks:

Evolution of total value of monthly mobile transfers received by all sampled households in Mozambique

Other examples also illustrate how financial services are helping the poor not only survive climate crises but take the first steps toward longer-term adaptation. Across Africa and parts of Asia, for instance, more than 4 million farmers receive loans and area-yield index insurance through agricultural insurance provider Pula and their many bank partners. The bundled product incentivizes farmers to switch to resilient seeds and protects them in case of climate-related losses. In India, SMV Green Solutions has helped 1,700 rickshaw drivers gain access to loans to purchase e-rickshaws. The e-rickshaws have vastly improved drivers’ health compared with manual ferrying; are less expensive, since drivers don’t have to buy petrol; and have lower emissions and thus a smaller environmental impact.

Providing financial tools for climate resilience is very complex

CGAP’s Leadership Essay on resilience described the complexity inherent in building resilience to the risks faced by poor people. Climate risk is even more complex than other common risks, and poor people’s typical risk-management strategies may not work very well in dealing with climate risks. There are three key aspects that make climate change more complex in a financial inclusion setting. 

First, climate shocks are mostly co-variant, meaning that they affect many people simultaneously. This is not the case with most risks that poor people have to manage. This makes traditional sources of resilience, such as informal financial services, unworkable for any significant length of time, since many need to draw on them simultaneously (i.e., not everyone can cash out of the savings group at the same time). Moreover, in times of crisis, formal financial-service providers sometimes suspend their operations. The resilience of any individual depends on the resilience of other people; of informal savings and insurance arrangements; of formal providers of infrastructure, from cellphone towers to agents; and even of government safety nets. 

Second, the impact of climate shocks will vary significantly based on the type of shock (especially if it has a slow rather than sudden onset) and the distinct locations of people affected by the shock. For example, city-dwellers affected by a flood will face different challenges and response approaches than rural residents who suffer through a drought that threatens their crops. This means they will also need different financial instruments. That is not the case with other risks such as fire, crime or illness, where the response mechanisms tend to be similar and where most people use the same set of financial tools to manage the risks.

Third, managing climate shocks is more complex than many other types of risks for vulnerable people, since they are difficult to predict and since they often play out through second- and third-order effects. Figuring out which adaptation response will be most effective, amid a wide range of unpredictable outcomes, is very difficult. For the poor to be truly resilient against the shocks of climate change, they must also have the knowledge, tools and resources to enable their long-term adaptation. The traditional patterns of livelihoods must adapt amid shifts in temperature, changes in rainfall, increased water scarcity, and continuing ecosystem changes. The need to shift away from traditional livelihoods — or to relocate, fleeing exposed locations — will again disproportionately disrupt the lives of the poor and the vulnerable. Developing financial services that support the poor in this uncertain transition will likewise be complex.

Challenges for providers offering climate-responsive financial products: Limited data and high costs

Along with all the complexities that climate risk brings to resilience-building, providers of financial services face two additional challenges: limited data and the likelihood of very high costs.

The lack of data on climate shocks and their impacts makes it difficult to accurately price a climate-related product, particularly insurance. Insurance actuaries require reliable historical data on the frequency and magnitude of shocks and their impact, but climate change has rendered past data an unhelpful predictor of the future. Even with accurate data, the all-in cost of a financial product that adequately covers poor individuals against climate risks is likely to be well above what that individual is able or willing to pay. 

Developing products that are offered by the private sector, and that are both sustainable for providers and affordable for clients, will not be easy —but we think it is possible through public private partnerships and innovation. Ingenuity will be essential because “business as usual” will not be enough. Some providers have already been grappling with these problems for years and they can point the way for others. For example, a growing number of insurance providers offer index-based insurance as a solution to the low-data/high-cost conundrum. Index-based insurance offers pre-specified payouts based upon a trigger event (such as too little, or too much, rainfall) rather than on direct evidence of loss or damage. This requires only aggregate data provided by a weather station or satellite imagery, rather than data on a specific individual or farm. In another example, microfinance providers learned, more than a decade ago, how to build resilience into their savings and loan programs in Bangladesh — a country that is highly vulnerable to climate change. For decades, Bangladesh has been hit with devastating floods, and they are now occurring with increasing frequency. Microfinance institutions (MFIs) build cushions within their balance sheets to allow them to provide fresh loans to farmers, thus helping them recover faster — often resulting in the repayment, over time, of both old and new loans. Such measures, however, will become increasingly complex. Pro-poor financial institutions are likely to struggle as climate shocks increase in frequency and intensity, and as costs and risks are driven to unprecedented levels.

In order to manage these challenges and offer sustainable products at affordable prices, providers will need to de-risk in various ways. A few mechanisms for de-risking and keeping costs affordable include:

Support by governments, especially through Public-Private Partnerships (PPPs): While the private sector will play an important role in developing financial products, it is difficult to believe that all the creativity and innovation in the world can result in a suite of products that cover expected climate-related shocks for the very poor at a price they can afford. Governments in developing countries, however, face heavy fiscal constraints and will confront many demands on public finance for climate change. Therefore, finding ways to maximize the role of the private sector, while ensuring affordability for the poor through PPPs, is essential. Not only will governments need to provide the basic enabling environment — stability, policy, regulation, supervision, and infrastructure — that is required for the private sector to flourish and develop innovative solutions, but governments will also need to offer price subsidies for the very poor and social safety nets to cover the highest-impact/lowest-frequency risks.

Risk Pooling and Diversification: Since climate risk is so highly co-variant, risk pooling (e.g., through reinsurance) is critical. In pooling arrangements, a group of insurance companies (collectively covering a variety of geographies, types of threat, etc.) share risks. If an insurance pool collectively covers multiple countries (and even regions) and multiple types of risks, the impact of one climate disaster is shared across many companies. There may be ways that digital financial services can enable broader risk pools for other types of financial services. The reason that informal financial services, like savings groups, work less well for climate risk is precisely the co-variance of the risk. If broader risk pools can be created with many savings groups (or, say, MFIs for credit), the risk of all group participants needing to access their savings or many microfinance clients defaulting at once can be reduced. 

Bundled Products: Another mechanism is offering bundled products that induce customers to purchase de-risking products like insurance that they otherwise would not buy by bundling them with other products they need and by doing so, reducing the risk and therefore the price of these products. Bundling indeed allows for cross-subsidization of products, and for a reduced risk overall, thus enhancing the overall risk-return nexus for the provider of the financial services. For example, farmers in Kenya significantly increased their profits in 2021 and were able to build capacity to weather external shocks thanks to Digifarm’s bundled service, which enables its 1.3 million farmers — through a single platform — to gain access to higher-quality seeds; to engage in learning; to connect with buyers; and to access loans and insurance together.

Some of the most interesting examples we see today combine several of these mechanisms. 
For example, the Caribbean Catastrophe Risk Insurance Facility (CCRIF) is “the world’s first multi-country, multi-peril risk pool based on parametric insurance.” CCRIF, which includes 22 Caribbean and Central American governments among its members, and Guardian General Insurance Limited have recently developed a new product aimed at protecting the poor against climate risks. This Livelihood Protection Policy is designed to help protect the livelihoods of low-income and vulnerable people such as small farmers and fishers. It covers extreme weather risk associated with both wind and rain across five Caribbean countries and offers quick cash payouts (within 14 days) following extreme weather events.  Guardian Insurance benefits from both the data that the CCRIF has accumulated on climate risk in the region over the last 10 years and the very deep expertise of the CCRIF staff in the development of innovative climate insurance solutions.  This is an example of a Public-Private Partnership and risk pooling across multiple countries and multiple types of threats. 

In another example, Pula, mentioned previously, is an agricultural insurance and technology company with a presence in more than a dozen countries globally. It also combines multiple strategies to manage risk and keep prices affordable.  Pula offers a bundled product of loans and insurance through bank partners and offers area-yield index insurance to reduce the need for data about individual claims. Pula also works through partnerships with funders and governments to deliver its services sustainably. In Kenya, for example, half of the premium charged per farmer for Pula’s area-yield index service is subsidized by the government. In Zambia, moreover, Pula delivers a hybrid weather index and an area-yield index insurance service through the government’s Farmer Input Supply Programme. Pula is currently expanding from its base in Africa to Asia and Latin America.
 
Despite these promising examples, very few solutions have scaled, and the gap between what poor people need and what is on offer in terms of financial services is tremendous. Globally, 1 in 5 adults still do not have access to a bank account or other formal financial service, let alone products that are designed to meet their needs in a time of crisis. New approaches, involving a broader set of stakeholders, are required. Otherwise, business as usual will exclude the poor to an even greater degree, and leave them unequipped to cope with, and adapt to, the many challenges climate change will bring upon them.

The financial inclusion community has an important role to play in helping the poor adapt to the climate crisis

CGAP is embarking on a four-year initiative on Strengthening Climate Resilience and Adaptation through Financial Services. Through this project, we aim to increase the effectiveness of financial services that help the vulnerable, especially women, to adapt and grow more resilient to climate change. Collective thinking and action will be critical: We hope to partner with many of our stakeholders — you! — as we seek to support the development of creative solutions to this most difficult of challenges. 

As a financial inclusion community, some of the questions we must answer are:

1. What new or improved financial services could help overcome the current gaps and barriers for poor people to build adequate resilience in the face of climate change? 
2. What is the experience of women in using financial services for climate resilience? How do women’s needs differ from those of men?
3. What are the main constraints for providers in offering climate-responsive financial services? How can these constraints be alleviated?
4. What is the role of the public sector, by comparison to the private sector, in offering climate-responsive financial products? How do we reconcile the need for cost recovery with affordability? How much should be financed by the poor themselves, by comparison with subsidies by governments?
5. What role can funders and development actors play to ensure that vulnerable people, especially women, are able to effectively access and use climate-responsive financial services?
6. How can financial regulators and policymakers strengthen the ability and incentives of financial-service providers to offer climate-responsive financial services, especially for women?

The IPCC has made it clear (with flashing red lights) that the world is on a trajectory toward a dangerous degree of climate change — and that the impact will be devastating. By 2030, climate change could push 130 million additional people into extreme poverty and could kill about 2.3 million people each year in poor countries. Compared to other unexpected shocks, such as Covid, we know that we should expect such impacts — and that it would be foolish not to prepare for them.

As a community focusing on financial inclusion, we can catalyze the development of creative new solutions to bolster the speed, reliability, sustainability, and affordability of financial services that help poor people build resilience and that help them adapt to a world of climate shocks. We need to make sure that poor people are part of the climate transition. That means improving their resilience to the physical impacts of climate change — and it also means increasing their access to the skills, technology, and markets that will be needed to adapt to far-reaching global change. Financial services are one important tool to facilitate this. 

If society leaves behind the world’s unbanked and under-banked people — who are among the most vulnerable to a climate crisis that they did not cause — then our efforts to create a more inclusive world will have failed. However, if we use our ingenuity to expand opportunities for the poorest, then our policymakers and our private sector will have taken a positive step to address chronic social needs while confronting the world’s most urgent environmental challenge. On this World Environment Day 2022, let us reaffirm that we indeed have “Only One Earth,” and that we must strengthen our determination to craft solutions that serve all of humanity.