Financial time bomb: The risks of climate inaction to the global economy

First appeared in Forbes India on 14th Feb 2023

The world is facing a financial time bomb due to economic risks from climate change. Climate change is causing billions in losses globally and affecting the economy. Transitioning to a low-carbon economy is necessary to reduce emissions, but difficult for financial institutions. An abrupt market sell-off could trigger a financial crisis.

For the last 300 years, fossil fuels have been the first love of economic development; they symbolise prosperity and happiness. Historically energy transition is to move from a less economical and efficient form of energy to a more efficient and more economical form, i.e., wood/biomass to coal and then to oil, and finally, the emergence of renewable energy sources such as solar, wind and green hydrogen. Earlier transitions were more because of commercial incentives, which bolstered economic growth and allowed greater energy access to the broader population. Nevertheless, this energy transition is different and is driven by the need to meet climate targets, the challenge of environmental change, and the market to decarbonise the global energy system.

Economic risks of climate change

Climate change is putting our weather system on steroids, and extreme weather events are everyday occurring. Hurricane “Ian” in the US resulted in the loss of US$ 100 billion and 101 lives; severe heatwaves in Europe during June and July last year brought the worst draughts in the previous 500 years; wildfires in Spain and Portugal were again a consequence of climate change event when both countries experienced driest climate in last 1200 years. Even India, according to Climate Change Performance Index (CCPI), released at COP 27 in November 2022, is amongst the top 5 best-performing countries in Climate Change, faced the wrath of nature through different events across the country on 241 of 273 days from January 2022 to October 2022, as per the report by the Centre for Science and Environment (CSE), a public interest research and advocacy organisation.

The CSE report mentions these events cost “2,755 lives, affected 1.8 million hectares of crop area, destroyed over 416,667 houses and killed close to 70,000 livestock.” It looks like we are living in a new normal, which includes more extreme events and disaster risks.

On July 27, 2022, the Reserve Bank of India (RBI) published a discussion paper on climate change and sustainable finance. It was different for several reasons; one, the tone and tenor of the document were quite away from the traditional style of the RBI; second, without mincing words, the central bank said that climate change is for real and is an economic risk; third, it mentions without mitigation, not just Indian industry, but the entire financial sector is vulnerable. So, in the future, it recommends that banks begin reflecting climate risk on their balance sheets and lending propositions, which will have clear implications for the Indian industry and its credit. Therefore, climate inaction has made us sit on a financial time bomb.

Physical consequences, such as severe weather conditions and the carbon transition resulting from shifting to a less carbon-dependent economy, are the two primary causes. Physical vulnerabilities are increasing in frequency and severity. These threats impacted the economy’s financial stability as they directly affected property, industry and agriculture. In 2019, climate catastrophes cost the world’s economy US$146 billion. Insurers covered a total of US$60 billion of it. According to Swiss Re, one of the biggest insurance firms, extreme weather occurrences are becoming more frequent and severe. This indicates that many sectors are preparing for future losses that will be considerably more serious. Moreover, these losses are not merely data or news headlines but have bearing on tens of millions of people.

Is climate change triggering the financial time bomb?

So, how might climate change lead to a financial disaster? Let’s take the potential consequences of catastrophic incidents like the sinking of Joshimath, Uttrakhand, as an example. In the event of such an incident in a populous location, not only would the property be destroyed, but there will be loss of human lives, nature, and livestock. According to reports, in 2021, natural disasters caused a loss of US$ 280 Bn, and approximately 60% of this total was uninsured. This implies that mortgage and commercial lenders like banks will never get repaid by uninsured homeowners or businesses. An increase in such incidents will result in bad loans, which may push banks to go for higher interest rates or extend fewer loans. Potential homebuyers and companies will find it difficult to obtain financing, and it won’t be long until the economy grids. The Global Financial Crisis (2007-2008) was brought on by banks realising that assets backed by real estate had almost lost all their value. Hence, the global economy shrank due to the subsequent credit crunch.

Transition to a Low-Carbon Economy

To safeguard ourselves against increasing natural calamities, we must transition from a high to a low-carbon economy. During fluctuating financial markets, businesses with a high carbon intensity lose value. This transition may be challenging for financial institutions if it is sudden. To achieve carbon neutrality, more nations are pledging to cut their CO2 emissions and use carbon-capturing technologies to bring in the necessary checks. However, many firms will need to alter their processes and operations to move towards carbon neutrality. For instance, most oil companies have yet to change strategies to incorporate more renewable energy sources in their operations. More renewables in the energy system will entail less consumption of oil and hence a decline in the company’s worth and, finally, less appeal to investors. This may lead to a market sell-off if businesses in an industry stay the same for a low-carbon future.

Financial markets may experience a shock if this occurs with more planning. There could have a ripple effect due to the interconnection of the global financial system, and industries that have already invested in green finance, like sovereign green bonds etc., will also lose. The financial markets worldwide are so intertwined that; a tsunami in Japan or wildfires in California might affect your stock investments or a worker’s retirement plans somewhere in Europe. A carbon tax is one factor that may influence investors’ positions in the market. These taxes, which would charge businesses based on their emissions, are now being debated in numerous nations. Governments expect that having these businesses pay more would encourage them to reduce their pollution to firms whose output is overly dependent on coal, gas, and oil. The banks that have lent money to these businesses may need stability.

How to reduce the risks posed by climate change?

The most fundamental step is to design, develop and implement the policies and investments to facilitate the transition to a new climate economy which is low carbon and climate resilient. Additionally, we need a focused approach to our financial systems because they are crucial for the operation of our economies. For instance, the European Union is putting the European Green Deal into practice by working on several initiatives. In an effort to revitalise the Indian economy and generate employment, the government of India recently unveiled sovereign green bonds and a significant US$4.3 billion investment in green technologies. These policies can help to revitalise economic growth while carving the path towards net zero. 

Investing in a low-carbon society may also have broader economic advantages. According to IMF, the world economy may profit from a 5% of GDP green investment, together with progressively rising carbon taxes and attention to those impacted by the transition; this can boost growth by 0.7% annually over the next 15 years.

Climate change is the biggest issue for society, and we may be the last generation who have the opportunity to overcome this challenge. This brings the greatest opportunities of our lifetimes too. We can generate avenues of growth and employment by investing in climate resilience and innovative technologies. Climate change has both a human and environmental toll and a substantial financial cost and could lead to the world’s next big financial crisis. It’s a financial timebomb in the making if not curbed on time.

Green Bonds – A leap towards energy transition

Yes, 2023 is shaping up to be a significant year for India with energy transition and green economy as the centre of discussion. Also, as the G-20 presidency, the country will have a key role in shaping global economic discourse and promoting growth and sustainable development.

The budget 2022-23 pledged to invest $4.3 billion in green technology to clean up the country’s economy and create jobs. Though, decision on utilisation this money for green initiatives is yet to be taken and government guidelines are awaited but the intentions are very clear.

In this endeavour, Green Bonds, which were announced during last budget, Ministry for Finance and Corporate Affairs has approved the final Sovereign green bonds framework* for India during the month of December 2022. This is a step closer towards India’s commitment under “Panchamrit”, which was elucidated by the Prime Minister during COP 26 at Glasgow in November 2021. Even though we have narrowly missed the target of 175 GW capacity by 15 GW, (till May 2022 country’s installed renewable capacity was ~160 GW), Sovereign Green Bonds will further strengthen India’s commitment towards its nationally determined contribution.

Climate change has direct threat to the existence of life on the planet and in last one century we are straining and exploiting natural resources in the name of economic and financial growth. Therefore, it’s critical to connect environmental projects with capital markets and investors and channel capital towards sustainable development – and Green Bonds are a way to make that connection.

Over the last few years, Green Bonds have emerged as an important financial instrument to deal with the threats of climate change and related challenges. Worldwide if we look at the trajectory of green bond framework, first it started with companies, when first issue was made in 2007 by European Investment Bank. Since then there were many countries, organisations and institutions who joined this bandwagon and have issued bonds with cumulative value of $US 1 Trillion. 

In India, Yes Bank was the first institution who issued Masala Green Bond in 2015 in the wake of increasing global demand of green bonds. Masala bonds are not typical Green Bond but off-shore issuance which are local currency dominated. Here, Yes Bank issued green bond to International Finance Corporation (IFC), the private sector wing of the World Bank. IFC on behalf of Yes Bank issued these Bonds in the London Stock Exchange. Since then many companies like Adani Renewables, Aditya Birla Group (ABG) and financial institutions are looking forward to issue Green Bonds.

Let’s see what are green bonds and how do they work and why its gaining so much of popularity across – So, there’s a whole new bond market within the bond market. Bonds as we know them work like this: An issuer, most often a company or a government, raises money by offering bonds to investors. They’re basically IOUs, an exchange for getting money up front, when you sell the bond, you pay the bond holder back over a certain amount of time with interest. Issuers use these bonds to raise money to invest in their business, employees, infrastructure, anything you name it. But green bonds are different. The fundamental differences that it’s about what it’s financing, first and foremost. Money raised from these are earmarked for projects that are positive for the environment. The one key difference is that the issuer makes a non-binding voluntary commitment to earmark the proceeds and use them for specific environmentally-friendly projects. So, it could be renewable energy, energy efficient buildings, clean transportation, clean water, but from a structure standpoint, they tend to be the same as the traditional bonds that issuer would bring to market, minus the green commitment.

Government of India is looking forward to raise some part of their regular market borrowing through Green Bonds. Last month, Reserve Bank of India (RBI) announced that it will, for the first-time, issue Sovereign Green Bonds worth Rs 16,000 crore, in two tranches of Rs 8,000 crore each in the current financial year. The RBI said it will issue 5-year and 10-year green bonds of Rs 4,000 crore each.

On 25th Jan, during maiden issuance, they got oversubscribed owing to robust demand. For the 10-year green bond – New GOI SGrB 2028 – the RBI received 170 competitive bids worth Rs 19,367 crore – nearly five times the notified amount of Rs 4,000 crore. Of this, the RBI accepted 57 bids worth Rs 3,948.646 crore. For the 5-year green bond, 96 competitive bids worth Rs 13,525 crore were received.  

Though experts are pointing out that India is little late on the scene as we were waiting for some sort of proof of concept but I think it’s a timey move by GoI. In 2021, sustainable bonds market topped US$ 650 billion which is 8% – 10 % of the total bonds issued worldwide. Access to financing is getting easier in addition to various Governments, globally, some big household names are getting into this space like by March 2021, Apple spending from “green bonds” hits US$ 2.8 billion; Pepsi issued US$ 1 billion in green bonds to fund its sustainability initiatives. In February 2021, Goldman Sachs enters green bonds market with US$ 800 million deal. 

The market here is bigger than just green bonds. According to Moody’s, by end of 2021 $490 billion of green, social and sustainability bonds combined were issued and issuance is growing. Sustainable bonds break out into three categories: Green, social, and sustainability. Social bonds would be used primarily for social purposes. It could be affordable housing, or micro finance. And the sustainability bond category here basically means a bond meets both green and social standards of issuance. The biggest slice of the pie goes to green bonds. So it’s a huge diverse mix. Banks, corporates and governments. Anyone issuing or the ability to issue a bond is issuing, especially when they have the eligible assets to do so. Most issuances so far have been considered investment grade. That means independent rating agencies say those issuers are most likely to repay their debts. The other side of the bond market is riskier, often called high yield bonds or even junk bonds. The buyers are the big pensions, the big asset managers.

The market is evolving to include sustainability-linked loans or bonds. The interest rate is typically tied to the achievement of some sort of sustainability target, the coupon could step up by 25 basis points, for example, if a targets not hit some point into the life of the bond. It’s almost as they’re setting themselves up that they could have a financial penalty, should they not achieve their goals. So, there’s only been about US$15 to US$ 20 billion of sustainability-linked bonds to date, but the vast majority of that has been in the last six months or so. So, a lot of growth potential there, just still very early stages to kind of size the market. And we’ll also see a rise in different labelled products like blue bonds or gender bonds Blue bonds have been issued as a way to look at marine projects or ocean or water projects. Under these bonds there are some gender bonds, last year in U.S. a bank issued social bond they called a racial equity bond.

Though the market is very big but accountability and regulatory aspects are at very nascent stage. Globally, when it comes to accountability, to date, it’s been largely, sort of a best practice, document-driven market. But at this point, it’s been a regulatory light market for the most part. The green bond principles, which are sort of a best practice document that was put out by the International Capital Market Association. For a green labelled bond, if the issuer is complying with the principles, the green bond principles, then there’s certain parameters, certain guidelines they have to follow. There’s four core requirements that these bonds must meet, but it’s a non-binding voluntary commitment. First is use of proceeds. It’s basically the legal document that details how the money raised will be used for green projects. And to determine what’s green, there’s what’s called a taxonomy. The taxonomy’s main objective is to help set the course on what is green. Think of it as a dictionary or catalogue of what we mean by green. The other core components include process for project valuation and selection, management of proceeds, and reporting. They’re all interconnected. And essentially, it advises issuers to keep up-to-date information on how the money is being used and the project’s environmental impact. How are you going to manage the proceeds during the time of the bond, you’re going to use a tracking system or you’re going to ring-fence it, the proceeds? And of course, how will you report on those is really the fundamentals on what the green bond principles is trying to lay out. All of this can be subject to second party opinions, external reviews, and even verifications and certifications. It’s not one of the four key principles, but it’s like it’s essentially a fifth and many issuers are doing it. And then they’ll oftentimes will bring an external reviewer in to provide an opinion on the credentials of the offering and whether it aligns with either the green bond principles. And that’s what investors actually rely on. They rely on that verification that second party opinion, or certification of the green bond. Think of those stamps we generally see on coffee or paper towels, even ice cream, that are meant to signify to buyers that whatever they’re buying is ethical or sustainable. When we pick up a product in the supermarket, and we make a decision on whether we buy the same product, but of a different brand, if one has been, you know, stamped by WWF or Rainforest Alliance, we have a tendency to go, “I trust that label.” It is a marketing component that comes with an assurance behind it that you can buy this product and know that the due diligence has been done. But issuers don’t have to do this, for instance in US, if the issuer decides to use all the money raised for something else, there’s no regulation in place to punish them.

In India, the framework for Sovereign Green Bonds comprises of Green Finance Working committee under the chairmanship of Chief Economic Advisor with some environmental specialists from NITI Ayog, representatives from Ministry of Environment, representatives from Ministry of Renewable Energy and so on. Additionally, there is an accountability mechanism which is being put across to keep check on the investors and its spending. More details are in the framework released last year.

The project and spending will be reviewed by an independent agency and report will be available in public domain. Also, a rating and performance evaluation mechanism has put in place, which is called a shading methodology; dark green, medium green and light green where dark green means excellent and project concurs with all the principles there is no risk of say “green washing”. Subsequently, medium and light green shades mean some concerns which investor has to work upon.

Climate risk is now a financial risk. Therefore, transparency is important for investors, in order for them to better understand the climate risk exposure to their investments. And that’s what the second opinion gives them: more transparency on these risks. Impact reporting has been very, very important since the very beginning of the green bonds, but it’s been an iterative process.

Therefore, in addition to moving large amounts of capital, Green bonds have the ability to catalysed a change in investor behaviours. Not only for green bonds, or for social bonds, or sustainable bonds, they may start asking questions about everything they invest in and that’s going to be the capital markets of the future.

Climate change poses the greatest threat to humanity. The effects of climate change can set back decades of progress made across globe. The scale of the issue is unsettling, environmental shocks will become more extreme and more frequent. No single government or institution can solve this problem alone and most importantly we are the last generation that can alter the course of climate change, and we require investment on a scale we have never seen before.

An Ecosystem where Homoeconomius = Homosapien !

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