This paper is part of the Fide Foundation’s GET-2 ESG Think-Tank final report from the 2024 Oxford Congress, titled “Driving Change: Exploring Opportunities and Challenges in Accelerating Sustainable Finance.”
ABSTRACT
Building Climate resilience entails various actions across policy, infrastructure, services, planning, education, and communication. We will approach this challenge from three different perspectives: the role of the private sector, the worldwide financing gap increasingly urgent in developing nations, and the involvement of central banks.
Businesses can enhance their resilience by integrating climate considerations into their existing risk management strategies, but this is a complex task. The main challenges faced by most countries worldwide are financing adaptation and disaster risk finance (DRF). Developing economies are especially susceptible to the impacts of climate change. Debt instruments and CAT bonds could potentially help bridge thegap. Central banks can significantly contribute to enhancing climate resilience within their mandates by gaining a better understanding of the repercussions of climate and environmental risks and their impact on the economy and the financial system. Access to information and data is crucial in this regard.
KEY FINDINGS
- Building climate change resilience in the private sector is essential to adapt to the impacts of climate change, such as extreme weather events, supply chain disruptions, and regulatory changes but it is a very complex task for businesses of all sizes and industries. Almost half of EU firms are concerned about natural hazards, yet less than a third have or plan to invest to mitigate climate risks.
- Climate change will require substantial investments to adapt to the new climate conditions as well as financial resources to mitigate the impact of climate disasters (disaster risk finance, DRF), particularly in developing economies. Financing adaptation and DRF are the main challenges for most countries around the world. Developing economies are particularly vulnerable to climate change. Only 5% of global climate finance flows 2021-22 was spent on adaptation. This implies an adaptation finance gap of US$194 – 366 billion per annum, albeit estimating adaptation finance needs is complex and figures are likely underestimated.
- Defining adaptation activities is challenging. Most taxonomies have climate adaptation as an objective, but approaches vary across countries. Unlike mitigation, there is no well-defined list of activities for climate adaptation and resilience.
- Central banks can play a crucial role in enhancing climate resilience within their mandates through different areas. The European Central Bank has developed since 2021 its own climate action plan and roadmap. Banco de España has published its first annual report wholly and exclusively dedicated to the financial disclosure of the climate-related aspects of its euro and non-euro-denominated non-monetary policy portfolios. Interestingly, sovereign debt, the asset class with the largest presence in investment portfolios and also on the balance sheets of central banks’ balance sheets has started to be analyzed from a climate risk perspective.
- Green bonds with a focus on resilience, biodiversity bonds, debt-for-nature swaps and Catastrophe bonds are some of the innovative instruments used to allocate funds towards investments to deal with the consequences of climate change
CONTENT
The challenges of businesses in climate risk climate management
There are different definitions of resilience to climate change. The IPCC offers a holistic approach on the concept by defining it as “the capacity of social, economic and environmental systems to cope with a hazardous event or trend or disturbance, responding or reorganizing in ways that maintain their essential function, identity and structure while also maintaining the capacity of adaptation, learning and transformation”. Improving climate resilience therefore involves assessing how climate change will create new, or alter current, climate-related risks, and developing the tools to better deal with these risks.
The EU policy framework lies the foundations to improve climate risk management through the Climate Law 2021 adaptation strategy, the inclusion of the “Do Not Significant Harm” principle in EU funding, the National Energy and Climate Plans, the requirements for Transition Plans in several regulations, the upcoming assessments of risks to critical infrastructure… Nevertheless, this policy framework and its implementation lack a coordinated approach to ensure competitiveness and there is a climate resilience investment gap.
Building climate change resilience in the private sector is essential to adapt to the impacts of climate change, such as extreme weather events, supply chain disruptions, and regulatory changes but it is a very complex task for businesses of all sizes and industries. Almost half of EU firms are concerned about natural hazards, yet less than a third have or plan to invest to mitigate climate risks.
Benefits include the ability to mitigate vulnerabilities, meeting disclosure and regulatory requirements, managing risks and corporate reputation, and gaining a competitive advantage, but there are many challenges and barriers that companies face in becoming more resilient including:
- Financial: Many businesses, especially small and medium-sized enterprises lack the financial resources to invest in the necessary infrastructure, technology, or research to protect their operations from climate impacts or find difficult to access finance, especially when the benefits are realized over the long term.
- Data and tools: Many companies lack the appropriate data, and tools to assess climate impacts and interpret the effects in their business models and processes. Understanding how local climate risks translate into business risks requires specialized knowledge.
- Technological: there are several barriers to technology development and implementation within the private sector, including the technology availability, expertise, and the ability to integrate new systems into existing infrastructure.
- Regulatory: the regulatory framework in the EU is increasingly complex and presents a significant challenge for businesses. Even more, regulatory uncertainty is one of the main concerns.
- Insurance: there is a need to develop insurance tools and frameworks limiting exposure for business to climate events that are becoming more and more frequent and severe.
How to bridge the financing gap
Climate change will require substantial investments to adapt to the new climate conditions as well as financial resources to mitigate the impact of climate disasters (disaster risk finance, DRF), particularly in developing economies. Financing adaptation and DRF are the main challenges for most countries around the world. Developing economies are particularly vulnerable to climate change. Only 5% of global climate finance flows 2021-22 was spent on adaptation. This implies an adaptation finance gap of US$194 – 366 billion per annum , albeit estimating adaptation finance needs is complex and figures are likely underestimated2 (CPI State and Trends in Climate Adaptation Finance 2023). Climate related disaster costs are increasing as well; the 2022 Pakistan’s floods ( $15 billion losses, 9% of GDP) was that nation’s most expensive weather disaster on record.
Defining adaptation activities is challenging. Most taxonomies have climate adaptation as an objective, but approaches vary across countries. Adaptation is often part of a larger investment (e.g. maintenance costs) and detailed project information is required to single out what can be categorized as adaptation and resilience. Unlike mitigation, there is no well-defined list of activities for climate adaptation and resilience. Adaptation taxonomies use different approaches ranging from a positive list of eligible projects and sectors (e.g in Sri Lanka) to high level principles of what constitutes adaptation (e.g ASEAN). For the EU, the approach is more complex; entities must perform a climate risk and vulnerability assessment to identify the most important physical climate risks material to its economic activity and implement a plan that outlines how and by when adaptation solutions will be implemented to address the identified physical risks. The World Bank has designed a Resilience Rating System that looks at the resilience of the project and the resilience through the project, that has informed the Climate Bond Initiative resilience taxonomy. There is now burgeoning activity on adaptation taxonomies.
Debt instruments the primary financial instrument for adaptation. Debt-for-climate adaptation swaps also support adaptation finance while tackling debt distress of issuers. Fiji’s sovereign green bond issued in 2017, the first sovereign green bond issued by a developing country, is one of the only sovereign labelled bonds in the world where most of the use of proceeds (more than 90 percent) went towards adaptation. BBVA Colombia and the IFC launched the first Biodiversity Bond to address key drivers of biodiversity loss. Several countries, including Ecuador, Barbados, Belize and Seychelles have recently issued debt-for climate adaptation swaps to reduce indebtedness, a major concern among several developing economies discouraging more adaptation investments.
CAT-bonds transfer the risk of catastrophe to investors, providing insurance as opposed to debt. CAT bonds are ESG-oriented investments that provide diversification opportunities to investors. CAT bonds are a financial instrument that transfers catastrophe risk (i.e. risks related to emergency catastrophe expenditures) from a sponsor (e.g. Jamaica) to bond investors. Sponsors receive a payout when a disaster event meets certain pre-defined criteria, and the payout is not repayable. Bond investors provide full funding at issuance ensuring that funds are promptly available for payout. A CAT bond is not a debt obligation for the sponsoring entity. Sponsors do not issue the bond, but a SPV or a third party (e.g. the World Bank, Jamaica CAT Bond Case Study6 ). CAT-swaps also transfer catastrophe risks to investors but in this case, there is not full funding at issuance from investors for payouts. CAT-bonds and CAT-swaps are insurance linked securities (ILS). They are ESG-oriented investments that provide diversification opportunities to investors as returns are uncorrelated with the economic cycle.
The role of Central Banks
Central banks can play a crucial role in enhancing climate resilience within their mandates through different areas. In recent years, central banks have made progress in incorporating climate change and sustainability into their work agendas, with the aim of understanding the potential implications for the financial system, defining their role in order to contribute to averting any resulting adverse consequences and promoting sustainable finance.
It must be acknowledged that leadership in this battle falls necessarily on governments. However, central banks can play a significant role acting as catalysts in many spheres, contributing by example. Progress is firstly determined by the need to properly understand the consequences of climate and environmental risks and their transmission channels to the economy and the financial system. In this connection, information and data availability are vital.
Central banks have stepped up their work in relation to climate change, especially since the creation of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) in December 2017. The aim of this network is to define and promote good practices, conduct analysis, foment climate risk management in the financial sector and contribute to mobilising the financing needed for a transition towards a sustainable economy. It was acknowledged in the first Progress Report that “climate-related risks are a source of financial risk. It is therefore within the mandate of central banks and supervisors to ensure the financial system is resilient to these risks”. The number of members has grown rapidly from the initial group of eight up to 138 members and 21 observers in May 2024. The main areas of work of the NGFS comprise: supervision and financial stability, monetary policy, scenario design and analisys, net zero for central banks (sustainable and responsible investment principles, disclosure, own operations), nature-related risks, capacity building. At the same time, these areas are being developed in each central bank according with their specific mandates and resources. In the case of the European Central Bank, it has developed since 2021 its own climate action plan and roadmap with the aim to better take climate-related financial risk into account in the Eurosystem’s balance sheet and to support the green transition of the economy in line with the climate neutrality goals of the European Union.
Regarding sustainable and responsible investment (SRI) principles, they have been a cornerstone of the Banco de España’s own portfolio investment policy since 2019. This approach is in line with Recommendation number 2 of the NGFS,5 which the Banco de España joined in April 2018, and with the ten recommendations published by the NGFS in 2024 to further the integration of SRI practices. Banco de España adopted, a thematic strategy in the form of a specific SRI portfolio through the direct investment in green bonds denominated in different currencies and holdings in green investment funds (denominated in US dollars and in euro) managed by the Bank for International Settlements (BIS).
In 2023 the Banco de España published its first annual report wholly and exclusively dedicated to the financial disclosure of the climate-related aspects of its eurodenominated non-monetary policy portfolios and in 2024 the second report extended the information to non-euro-denominated portfolios. This publication is part of the annual disclosure commitment announced by the Eurosystem national central banks and the European Central Bank (ECB) in February 2021, as part of the common stance for applying SRI principles in such portfolios. The 20 Eurosystem Nacional Central Banks and the ECB published this formation for the first time in March 2023. The report follows the recommendations of the Task Force on Climaterelated Financial Disclosures (TCFD) and provides information of climate-related aspects of the own or investment portfolios (i.e. non-monetary policy portfolios) in terms of: i) governance, ii) strategy, iii) risk management and iv) metrics and objectives, and includes, in particular, details on the calculation of different metrics applied to the investment in sovereign assets.
TCFD recommends the use of four metrics to characterise and assess investments from a climate perspective: i) weighted average carbon intensity (WACI), ii) total absolute GHG emissions, iii) carbon footprint, and iv) carbon intensity. These metrics are designed to classify investments in assets issued by financial and, particularly, non-financial firms based on their climate change impact. Yet in central banks’ portfolios other types of assets generally tend to predominate. Indeed, sovereign debt is the predominant asset class in the Banco de España’s investment portfolios. For this reason, the metrics were adapted to apply them to assets such as sovereign bonds. More specifically, in the case of sovereign bonds three approaches were considered in Banco de España (2024) to calculate the metrics mentioned below:
- country (or production) approach, under which all GHG emissions produced in a
country, including those linked to domestic consumption and exports, are assigned
to the sovereign issuer, - government approach, which considers the central government’s GHG emissions,
- consumption approach, which includes the GHG emissions produced in the country,
correcting for trade effects; emissions assigned to imports are included while those
assigned to exports are excluded.
It should be noted that the country and consumption approaches both give rise to a double counting problem that results in an upward bias in the indicators of any portfolio that includes securities other than sovereign bonds. This is because the GHG emissions of the non-sovereign agents will also be included in the total emissions produced in the country.
The analysis presented in Banco de España (2024) presents a gradual improvement over recent years in the quality of both the euro and non-euro denominated investment portfolios, in terms of their contribution to combating climate change. Furthermore, the proportion of these portfolios invested in green bonds has progressively increased in recent years, standing in 2023 at 7.1% for eurodenominated portfolios and at 3% for non-euro portfolios.
Conclusions and Proposals
- Resilience to climate change requires companies to take a holistic approach, combining adaptation to climate impacts with mitigation of their emissions. Becoming climate resilient will not only strengthen their ability to face current and future crises but can also bring new opportunities for growth and leadership in a world increasingly aware of the need to protect our planet. But, as the Draghi report states, the EU must have a «coherent plan» to decarbonize, otherwise, the climate objectives risk «going against» competitiveness and growth.
- Some financial instruments can contribute to bridge the financing gap of managing climate resilience. Debt instruments are the primary financial instrument for adaptation. Debt-for-climate adaptation swaps also support adaptation finance while tackling debt distress of issuers. In addition, there are other instruments such as CAT-bonds and CAT-swaps, which are insurance linked securities (ILS). They are ESG-oriented investments that provide diversification opportunities to investors as returns are uncorrelated with the economic cycle.
- Sovereign debt is the asset class with the largest presence in investment portfolios and also on the balance sheets of central banks’ balance sheets. However, it is also the least analyzed asset class from a climate risk perspective. Some central banks are making an effort in this regard. Banco de España (2024) has adapted the recommendations of TCFD to start calculating some metrics on sovereign debt. This analysis presents a gradual improvement over recent years in the quality of both the euro and non-euro denominated investment portfolios.
AUTHORS
Cristina Rivero Fernández
Director of the Industry, Energy, Environment and Climate Department. CEOE.
Eva Mª Gutiérrez
Lead Financial Economist, Financial stability and integrity unit, World Bank.
Clara González
Analysis and Market Intelligence Division, Banco de España
María Folqué
Head of Sustainability, FundsPeople. Member of the Scientific Committee Oxford 2024
Oxford/24 Final Report:
This paper is part of the Fide Foundation’s GET-2 ESG Think-Tank final report from the 2024 Oxford Congress, titled “Driving Change: Exploring Opportunities and Challenges in Accelerating Sustainable Finance.” Held at Jesus College, Oxford on September 18th, 19th, and 20th, 2024, the Congress brought together world leaders in finance, regulation, and sustainability. This comprehensive report consolidates key insights from the event, offering strategic recommendations to financial institutions and regulators on transitioning to a low-carbon economy and reaching net-zero greenhouse gas emissions by 2050.
The full report can be found at: https://bit.ly/oxf24-report
