Exclusion Risks in Climate-Related Financial Regulation: An Analytical Framework

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Executive Summary

Fighting climate change, preserving financial stability, and ensuring financial inclusion are deeply interconnected goals (Knaack and Zetterli, 2023). Inclusive finance is vital for achieving climate goals, as it enables vulnerable groups—such as smallholder farmers, low-income segments, and micro, small, and medium enterprises (MSMEs)—to adapt to climate risks, mitigate negative impacts of climate change, and participate in the green transition. At the same time, a stable, safe, and sound financial system is a key precondition for inclusive finance to support the global climate agenda. However, climate risks increasingly threaten financial stability by jeopardizing economic growth and the sector's ability to remain resilient and serve the economy (Feyen et al 2020a). Financial instability could amplify financial exclusion, and this would further hinder the ability of marginalized groups to contribute to the fight against climate change, accelerating its negative impact over the economy and reinforcing financial instability. This potentially vicious cycle could be acute in emerging markets and developing economies (EMDEs), which face higher climate risks and larger underserved populations.

In this setting, climate-related financial regulation arises as crucial to preserve financial stability while supporting climate finance. An increasing number of financial sector authorities (FSAs) are adopting climate-related financial regulation, but many struggle to understand or fail to appreciate the significant implications for financial inclusion. Most of these regulations introduced by EMDEs follow international guidance and the steps taken by advanced economies. For the purposes of this paper the following are considered climate-related financial regulation: i) requirements to address climate and other environmental risks; ii) disclosure requirements; and iii) green or sustainable finance taxonomies and product standards. These regulations seek to mitigate risks posed by climate change on the financial sector; increase transparency and support green or sustainable finance. However, such regulations could introduce financial exclusion risks. For instance, faced with increased climate-related regulatory requirements, financial service providers (FSPs) could find it uneconomical to serve low-income groups, particularly those more exposed to climate-related risks.

This paper provides an analytical framework for FSAs in EMDEs to examine how climate-related financial regulation could disproportionately affect access to credit among vulnerable groups in EMDEs, with the aim of identifying measures to not only minimize the exclusionary risks of regulation, but also fuel the virtuous cycle between stability, climate resilience and financial inclusion. The focus on credit in this paper is due to its prominence as the main form of financing available to these groups in EMDEs, and because a good portion of the regulatory action in EMDEs has been directed toward lending activities.

The framework (summarized in the Figure 1) comprises six impact pathways through which climate-related financial regulation can reduce the ability or the incentives for FSPs to serve these segments. First, regulation can impose additional credit underwriting requirements and limit or discourage lending to certain activities and sectors, introducing new customer eligibility barriers. Second, regulation can lead to increased costs for FSPs and customers. Third, they could lead to reduced access to funds for FSPs to meet the climate adaptation and resilience needs of vulnerable groups. Fourth, FSPs may experience increased capacity constraints, leading to conservative practices and exclusionary risk management approaches. Fifth, uncertainty about the scope and outcome of increased supervisory scrutiny in the face of new, complex regulation may prompt FSPs to engage in over-compliance, favoring larger, less risky borrowers. Finally, increased reputational and litigation risks stemming from non-compliance or grey areas in the regulation may lead FSPs to adopt risk-avoidance behaviors, disproportionately impacting highly vulnerable segments.

These pathways are not independent transmission channels, but often interrelated and mutually reinforcing. For instance, new regulatory requirements or guidance on client eligibility for lending operations – some of which could lead to exclusion – could increase costs for FSPs, which could lead them to impose additional eligibility criteria on new borrowers, to ensure profitability. The purpose of presenting the pathways separately is to highlight and illustrate the various ways climate-related financial regulation could contribute to financial exclusion, because exclusion risks may be difficult for FSAs to detect and there is limited empirical evidence to date. Our intent is to help FSAs identify exclusion risks so they can design regulatory, supervisory, and non-regulatory measures that could counter exclusion risks. Finally, these pathways consider potential exclusion risks from all types of finance, although inclusive climate finance may be particularly impacted.

FSAs in EMDEs must aim to preserve financial stability and promote climate finance while minimizing financial exclusion risks. Adopting a proportional approach (risk and principles-based, consultative and gradual), fully consistent with international standards and guidance by standard setting bodies(SSBs),[1] will help FSAs meet the needs of vulnerable groups while containing additional costs imposed on FSPs. They can start by identifying the challenges FSPs face when serving the most vulnerable and consider specific measures to accommodate these segments. Relatedly, green or sustainable finance taxonomies need to be designed with due account to each country’s economic, social and regulatory context. The process should be guided by clear supervisory expectations and supervisors and FSPs should be educated and reminded about the risks of exclusionary overcompliance.

The risk of financial exclusion from climate-related financial regulation is particularly acute in those EMDEs with institutional weaknesses. For example, weak enforcement of environmental laws, high levels of MSME informality and capacity limitations such as poor climate risk data, limited expertise at FSPs and MSMEs, which not only amplify the exclusionary potential of regulation but also limit the effectiveness of tools designed to promote inclusive climate finance. Addressing these challenges requires a holistic approach that maximizes synergies across public and private sector actions and different policy goals including financial sector development, financial inclusion and the climate agenda.

EMDEs must ensure that their climate agendas are tailored to their unique contexts and needs, implementing a diverse set of policies and interventions in addition to regulatory reforms. These include market support mechanisms, tools to promote inclusive climate finance, and robust responses to climate shocks. Additionally, SSBs and international organizations should more explicitly integrate financial inclusion into their work on climate-related financial regulation, including assessing uneven regulatory impacts in EMDEs. They can play a critical role in developing methodologies to harmonize green or sustainable taxonomies, help FSAs and FSPs tailor their transition plans, and provide specific regulatory and supervisory guidance for FSAs as needed.

Finally, further research is needed to: i) enhance empirical evidence of the impact of climate-related financial regulation on credit provision and expand it to cover the provision of other financial services such as insurance; ii) explore effective approaches for the application of the principle of proportionality in climate-related financial regulation, for example through specific regulatory adjustments such as thresholds or exemptions and related supervisory practices; iii) analyze consumer protection risks arising from the growing offer of green/sustainable financial products; iv) evaluate the effectiveness of existing tools designed to promote inclusive climate finance and explore alternative strategies that could better serve vulnerable populations; and v) explore technology-enabled solutions for FSPs to implement climate-related financial regulation while promoting resilience and adaptation via inclusive financial products and services.

 [1] For instance, BCBS (2022b).