Green Finance
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Role of the financial sector in addressing climate change
- The financial sector has an important role to play in the fight against climate change by supporting reductions in climate change risk and mitigating the impact of adverse climate events.
- Long term institutional investors can help with rebalancing and redistributing of climate related risks and maintaining financial stability.
- Hedging instruments (e.g., catastrophe bonds, indexed insurance) help insure against increasing natural disaster risk.
- Other financial instruments (e.g., green stock indices, green bonds, voluntary de-carbonization initiatives) can help re-allocate investment to “green” sectors.
Oversight, disclosure, and regulatory adaptation
- Central banks and other regulators are adapting frameworks and practices to address the multifaceted risks posed by climate change.
- Improving climate risk disclosure and classification standards will help financial institutions and investors better assess their climate-related exposures—and help regulators better gauge system-wide risks.
- The IMF is working with the Network of Central Banks and Supervisors for Greening the Financial System and other standard-setting bodies to promote green finance more broadly and developing climate-related stress tests.
Key research findings and thematic evidence
- IMF Working Paper, June 05 2020 — "This Changes Everything: Climate Shocks and Sovereign Bonds":
- Investigates impact of climate change vulnerability and resilience on sovereign bond yields and spreads in 98 advanced and developing countries over the period 1995–2017.
- Finds that vulnerability and resilience to climate change have a significant impact on the cost of government borrowing, after controlling for conventional determinants of sovereign risk.
- Finds that countries more resilient to climate change have lower bond yields and spreads relative to countries with greater vulnerability.
- Partitioning the sample reveals effects are much greater in developing countries with weaker capacity to adapt to and mitigate the consequences of climate change.
- Global Financial Stability Report, April 2020 — "Markets in the Time of COVID-19 | Chapter 5: Climate Change: Physical Risk and Equity Prices":
- Projects disasters as a result of climate change will be more frequent and more severe, which could threaten financial stability.
- Shows the impact of large disasters on equity markets, bank stocks, and non–life insurance stocks has generally been modest over the past 50 years.
- High levels of insurance penetration and sovereign financial strength can help preserve financial stability in the face of climatic disasters.
- Does not find that aggregate equity valuations—as of 2019—reflect the predicted changes in physical risk under various climate change scenarios, suggesting investors do not pay sufficient attention to climate change risks.
- Recommends better disclosure of exposures to climatic disasters and stress testing for financial firms to help preserve financial stability, complementing policy measures to mitigate and adapt to climate change.
- Global Financial Stability Report, October 2019 — "Lower for Longer | Chapter 6 Sustainable Finance":
- Notes sustainable finance incorporates environmental, social, and governance (ESG) principles that are becoming increasingly important for borrowers and investors.
- States ESG issues may have material impact on corporate performance and may give rise to financial stability risks via exposure of banks and insurers and large losses from climate change.
- Observes lack of consistent evidence of outperformance of sustainable investing strategies, yet investor interest in ESG factors has continued to rise.
- Highlights that ESG related disclosure remains fragmented and sparse, partly due to associated costs, the often voluntary nature of disclosure, and lack of standardization.
- Recommends policymakers develop standards, foster disclosure and transparency, and promote integration of sustainability considerations into investments and business decisions.
- Finance & Development, December 2019, Vol. 56, No. 4 — "Fifty Shades of Green":
- Calls for a new, sustainable financial system to stop runaway climate change.
- Commentary, May 29, 2020 — "Equity Investors Must Pay More Attention to Climate Change Physical Risk":
- Illustrates economic cost examples: the damage from the 2011 floods in Thailand amounted to around 10 percent of Thailand’s GDP.
- Notes by some estimates the total costs of the 2018 wildfires in California were up to $350 billion, or 1.7 percent of U.S. GDP.
- States that over the past decade, direct damages of climatic disasters are estimated to add up to around US$ 1.3 trillion (or around 0.2% of world GDP on average, per year).
- October 10, 2019 — "Connecting the Dots Between Sustainable Finance and Financial Stability":
- Emphasizes investors increasingly consider non-financial issues such as unsafe working conditions, child or forced labor, and environmental impact on protected areas when directing capital.
Policy recommendations and practical actions
- Improve climate risk disclosure and classification standards to enable better assessment of climate-related exposures by financial institutions and investors and to allow regulators to gauge system-wide risks.
- Develop and promote climate-related stress tests for financial institutions.
- Foster coordination between the IMF, central banks, supervisors, and standard-setting bodies (including the Network of Central Banks and Supervisors for Greening the Financial System) to promote green finance.
- Policymakers should develop standardized ESG disclosure frameworks, promote transparency, and encourage integration of sustainability into investment and business decisions.
- Complement mitigation and adaptation policy measures with enhanced disclosure and stress testing to preserve financial stability in the face of increasing physical climate risks.
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