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Climate Change and Effects on Financial Stability: The role of Ghana’s financial industry

In November 2019, the Bank of Ghana launched The Ghana Sustainable Banking Principles and the Sector Guidance Notes. The regulator launched these principles in line with best practices from the globally recognised Environmental, Social and Governance (ESG) frameworks, such as the IFC Performance Standards, the United Nations Global Compact, United Nations Environment Program Finance Initiative (UNEPFI) and the Equator Principles among others.

The Principles are to assist banks in Ghana to respond to the emerging global megatrend issues, such as human security, anti-money laundering, socially responsible stewardship, information communication transparency and disclosure, corporate integrity, environmental and climate change. Sustainability is, among others, about preserving the natural resources and climate for future generations.

In Ghana, like in many developing countries, a significant proportion of projects are being financed by universal banks. However, banks’ funding is used for activities which impact adversely on the environmental quality and social standards. For instance, activities of mining, forestry, and cocoa induced agricultural expansion has caused the reduction in the total forest cover from 32.7% total land area in 1990 to 21.7% in 2010.

Again, funding of heavy mechanical equipment by Banks has contributed to air emission through the operations of these equipment in forestry and logging. Most manufacturing companies, funded/supported by banks, rely significantly on fossil fuel based energy source which release air pollutants, such as Sulphur dioxide, and greenhouse gases that eventually contribute to climate change.

Thankfully, we are experiencing a changing business direction, which recognizes that a strategic integration of economic, social and environmental factors in decision-making is not only a value addition to banks’ businesses but also help to reduce economic imbalance and social inequality, as well as mitigate the rate of environmental pollution and the effects of climate change.

WHAT RISK DOES CLIMATE CHANGE POSE TO THE FINANCIAL SYSTEM?

The Network for Greening the Financial System (NGFS), created in December 2017, quickly recognised that “climate-related risks are a source of financial risk. It is therefore within the mandates of central banks and supervisors to ensure the financial system is resilient to these risks” (NGFS (2018), p. 3). There are two main channels through which climate change can affect financial stability: Physical risks and Transition risks.

Physical Risk:

Climate change means we may face more frequent or severe weather events like flooding, droughts and storms. These events bring ‘physical risks’ that impact our society directly and have the potential to affect the economy. Virtually every sector of the economy faces risks from the short- and long-term physical effects of climate change—impacts across the entire business value chain, from raw materials through to the end users. 

For financial institutions, physical risks can materialize directly, through their exposure to corporations, households, and countries that experience climate shocks, or indirectly, through the effects of climate change on the wider economy and feedback effects within the financial system. Climate impacts can affect labor and operations, physical assets, supply chain, distribution chain, consumers, and the communities on which companies depend. Some impacts will be direct (e.g. property damage due to flooding), while others will be indirect (e.g. reduced water availability due to increased demand from others). 

The destruction of capital and the decline in profitability of exposed firms could induce a reallocation of household financial wealth. Climate-related physical risks can also affect the expectation of future losses, which in turn may affect current risk preferences. For instance, homes exposed to the negative impact of the sea would sell at a discount relative to observationally equivalent unexposed properties equidistant from the beach. 

Transition Risk:

As Ghana joins the rest of the world to move towards a less polluting, greener economy, some sectors of the economy face big shifts in asset values or higher costs of doing business. Transition risks are associated with the uncertain financial impacts that could result from a rapid low-carbon transition, including policy changes, reputational impact, technological breakthroughs or limitations, and shifts in market preferences and social norms. 

The Government of Ghana and Switzerland signed a bilateral agreement on 23rd November 2020, which brings the cooperative approaches of the Paris Agreement to life. The bilateral agreement sets the framework conditions for the cooperation. The first project foreseen will enable clean cooking and solar lighting and benefit up to five million Ghanaian households. The new partnership will enable the adoption of green and low carbon technology solutions across the country resulting in a plethora of social and environmental benefits. 

It’s not that policies stemming from deals like the Paris Climate Agreement are bad for our economy – in fact, the risk of delaying action altogether would be far worse. Rather, it’s about the speed of transition to a greener economy – and how this affects certain sectors and financial stability. One example is that of energy companies. If government policies were to change in line with the Paris Agreement, then two thirds of the world’s known fossil fuel reserves could not be burned.

This could lead to changes in the value of investments held by banks and insurance companies in sectors like electricity, oil and gas. The move towards a greener economy could also impact companies that use a lot of energy to make raw materials like steel and cement.

Physical and transition risks, together, can materialize in terms of financial risk in five main ways: 

Credit risk: climate-related risks can induce, through direct or indirect exposure, a deterioration in borrowers’ ability to repay their debts, thereby leading to higher probabilities of default (PD) and a higher loss-given-default (LGD). Moreover, the potential depreciation of assets used for collateral can also contribute to increasing credit risks.

Market risk: Under an abrupt transition scenario, financial assets could be subject to a change in investors’ perception of profitability. This loss in market value can potentially lead to fire sales, which could trigger a financial crisis.

Liquidity risk: Although its manifestation is low, liquidity risk could also affect banks and non-bank financial institutions. For instance, banks whose balance sheet would be hit by credit and market risks could be unable to refinance themselves in the short term, potentially leading to tensions on the interbank lending market.

Operational risk: this risk seems less significant, but financial institutions can also be affected through their direct exposure to climate-related risks. For instance, a bank whose offices or data centres are impacted by physical risks could see its operational procedures affected, and affect other institutions across its value chain.

Insurance Risk: For the insurance and reinsurance sectors, higher than expected insurance claim payouts could result from physical risks, and potential underpricing of new insurance products covering green technologies could result from transition risks. As weather-related insurance claims rise, insurance companies have more to pay out, increasing everyone’s premiums. If companies and households are not insured, they may need to foot the bill themselves. In both cases, the consumer ends up paying more.

HOW DO BANKS COME IN?

Let’s start with the basics! Banks policies, processes, procedures, and necessary frameworks should be re-aligned to ensure that all transactions being considered for funding include adequate provision for actions necessary to prevent, control and mitigate negative impact on the environment and communities, and to improve environmental quality. What is the game plan of Banks to meet the 2024 full adoption deadline of the Sustainable Banking Principles as set out by Bank of Ghana?

Pursuant to Principle 1 of the Bank of Ghana Sustainable Banking guidelines and drawing upon the Equator Principles, IFC Environmental and Social Sustainability Performance Standard 1, UNEPFI’s Guide to Banking and Sustainability and UNEPFI’s Principles for Positive Impact Finance, the Bank of Ghana expects Financial Institutions to work with clients to identify, measure, mitigate and monitor environmental and social risks in our lending and other financial products and services. Banks are also expected to identify opportunities to encourage environmental and social improvements through our products, services and client interactions. 

Banks in Ghana must aim at integrating social and environmental principles in all its operations and ultimately to review and manage potential social and environmental risks in its lending and investment processes and activities. It is incumbent on all Universal Banks in Ghana to work towards full implementation of the Sustainable Banking Principles by 2024 in line with Bank of Ghana guidelines and directive.

Our funding approach to the 5 specific sectors (Oil & Gas, and Mining; Agriculture & Forestry; Power and Energy; Construction & Real Estate; and Manufacturing) as identified by Bank of Ghana must be responsible and sustainable in such a way that it would eliminate any potential risk, now and in the future. 

In July 2019, Ghana became the third country to sign a landmark agreement with the World Bank that rewards community efforts to reduce carbon emissions from deforestation and forest degradation. The economy would eventually transit to fully using carbon pricing and other fiscal policies to reduce emissions and mobilize revenues.

The financial system can play an even more fundamental role, by mobilizing the resources needed for investments in climate mitigation (reducing greenhouse gas emissions) and adaptation (building resilience to climate change) in response to price signals, such as carbon prices. In other words, if Ghana fully implements policies to price in externalities and provide incentives for the transition to a low-carbon economy, the financial system can help achieve these goals efficiently.

According to IMF Finance & Development reports of December 2019, global investment requirements for addressing climate change are estimated in the trillions of US dollars, with investments in infrastructure alone requiring about $6 trillion per year up to 2030 (OECD 2017). Most of these investments are likely to be intermediated through the financial system. From this point of view, climate change represents for the financial sector as much a source of opportunity as a source of risk.

To conclude, our attempt to fully comply with these principles and transit to a more sustainable and responsible banking would lead to a more guided and cautious lending to the 5 sectors. However, the potential impact on the environment stemming from the reduction in physical risk will be enormous- the reverse holds.

At a point, some Banks may avoid doing business with clients in sectors that undertake business activities that pose such high levels of environmental risk. In this case, an “exclusions list” should be kept which would then require that Bank staff are effectively trained to be able to identify such businesses and inherent risk. 

Physical and transition risks are usually assessed separately, given the complexity involved in each case. However, they should be understood as part of the same framework and as being interconnected. A strong and immediate action to mitigate climate change would increase transition risks and limit physical risks, but those would remain existent. In contrast, delayed and weak action to mitigate climate change would lead to higher and potentially catastrophic physical risks, without necessarily entirely eliminating transition risks. Delayed actions followed by strong actions in an attempt to catch up would probably lead to high physical and transition risks.

Any action or inaction of Commercial Banks in Ghana with regards to environmental degradation, resource depletion, deforestation, and greenhouse gas (GHG) emissions and climate change could place financial institutions in situations in which they might not have sufficient capital to absorb climate-related losses. In turn, the exposure of financial institutions to physical risks can trigger contagion and asset devaluations propagating throughout the financial system. 

Banks must play their part and play it well!

Source:Kenneth Owusu Asante Amponsah

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