Climate change will have broad implications on how financial institutions identify, assess, and manage a range of risks and opportunities. Whether in the form of the physical impacts of climate change or transition risks due to the policies and market shifts to stabilize and reduce greenhouse gas emissions– many financial institutions are gradually recognizing the importance of understanding and addressing climate risks in their existing portfolio and operations, as well as in pipeline and future investments.
Financial institutions have been aware of the issue of climate risks for more than 10 years, but more recently, the increased frequency of extreme weather events as a result of a warmer planet have raised concerns that physical impacts from climate change could potentially pose a significant financial exposure for banks’ portfolios across all asset classes. Financial institutions have begun to recognize that adapting to these changes is not only about physical infrastructure but also about how they are exposed financially to these climate risks.
The recent report of the Task Force on Climate-Related Financial Disclosures (TCFD) underscores this growing recognition of the materiality of climate risks in the private sector, and especially to the financial sector. The TCFD report outlines emerging issues regarding the disclosure of physical, liability and transition risks associated with climate change and will prove a useful roadmap to engage private companies and financial institutions to address their specific knowledge gaps and climate vulnerabilities and to develop resilience metrics, analytics, and standards.
The private sector usually frames climate risks from a risk management perspective, and are more often taking practical steps to protect business operations and continuity, supply chains, and property. Even so, businesses find it very difficult to calculate the returns on resilience investments due to the uncertainty of climate-related risks and how bad their effects will be. Now, a growing number of analysts view one organization’s climate risk as another’s opportunity, as reflected by the demand for private “climate resilience solutions,” or products and services that protect buyers from a range of climate risks. In the agricultural sector, these include new weather and climate analytics, climate-resistant seeds, crops, and methods, financial and insurance products that incentivize resilience building, water-efficient technologies, flood control, and site drainage, insulation against heat, and many other products and services.
The PROADAPT program was launched in 2013 by the Inter-American Development Bank (IDB), in partnership with the Nordic Development Fund (NDF), to support climate resilience in SMEs and their supply chains, and to foster business and investment opportunities in private resilience solutions. In addition, PROADAPT supports thought leaders and innovators in the development and dissemination of practical tools that highlight opportunities for business and investment in climate resilience. For PROADAPT and IDB, the need to support financial institutions in their efforts to address climate risk is directly linked to supporting climate resilience in smaller firms and their supply chains.
Recently, Price Waterhouse and Coopers (PwC) Brazil, together with the University of California, San Diego, were hired through the PROADAPT program to develop a financial tool that analyzes the credit behavior of agribusiness clients in the semi-arid region of Bahia, Brazil. The study incorporates the effects of climate change as a brand-new variable to the traditional credit scoring model used by financial institutions. By including such a tool, the banks will be able to understand their clients’ risks better and then be able to incorporate them in their credit scores. Not only banks could benefit from such a tool but also small farmers, who seek different methods to ensure their crops to succeed, such as by using resilience tools like for example artesian wells and climate resilient seeds. This type of analysis allows investors to allocate resources more effectively to small farmers and to help develop the awareness and the market for climate resilient tools and technologies. Moreover, based on these analyses, banks will be able to work with differentiated interest rates for each rural borrower, according to the risk of each of these small farmers.
The results of the study show that the climate variable is an important factor to be considered by financial Institutions in their credit risk analysis. A credit scoring model that considers a climate variable allows the financial institution to predict a more accurate probability of default, based on each crop and their responses to extreme weather events. This means that, if banks start considering this variable in their analysis, it will be possible to reduce their own risks, increase the demand for climate resilience tools and thus resulting in less vulnerable clients and better outcomes for the banks.
The other objective of the study was to analyze the impact of the use of resilience tools on the payment capability of small farmers. When shocks like heat, drought or flooding occur, borrowers in the study were more likely to default, but this effect is diminished when the farmers use various types of water storage technologies. The conclusion is that investments in water storage technology help to climate-proof the productive continuity and thus the credit score of that farmer. The implication of this is that financial institutions should consider concessional loans to farmers willing to install such equipment since their risk of default would be reduced as a result. More importantly, considering that the frequency and severity of such shocks are about to increase, these investments could play an increasingly important role in protecting the financial market in agriculture from climate-driven default.
The conclusion of these findings is that climate change should be a significant component in credit scoring models for small farmers in climate-sensitive regions. Furthermore, the demand for products such as IDB Invest’s Green Lines of Credit will probably increase as will the interest to work with financial institutions to invest in climate resilience tools and to identify climate business opportunities.
If you want to know more about how climate change and credit for small farmers are related, please join our event “Climate risk and access to finance: Could increased climate resilience mean lower default rates among small businesses in agriculture?” on October 4th, 2018 at 12 p.m.