Financial Aspect of Climate Risk Management

By
Prajesh Gupta
School of Business Management
NMIMS, Mumbai
Batch 2015-17
MBA Core
Mob no: 8879598814

Financial Aspect of Climate Risk Management

Climate change is a lethal and destructive force. In the recent past major
climatic events like floods, tsunamis etc. have led to substantial destruction
of wealth. Such events have highlighted the need of mechanisms for risk
sharing of the losses and restoring the lost human and infrastructural capital.
The climate change agreement declared on December 12, 2015 was one of
the highlights of the year. It showcased the resolve of various nations in
fighting climate change. It was a welcome change from Copenhagen.
Climate Change and its Effects
The major target for financial sector is to provide jobs, economic welfare to
the thriving population, without damaging environmental balance. It is the
role of the financial sector to help in managing climate risk and help society
recuperate from it. Any climate risk directly or indirectly affects the financial
sector in a huge manner. Whenever a climatic catastrophe occurs, the
number of insurance claims rise exponentially. Global Insurance claims have
risen from 5.1 billion US dollars annually in the 1970s to 27 billion US dollars
per year in 2014.
Figure 1: Losses due to various climate scenarios

Source: World Resources Institute

Climate variability also affects agricultural sector in a major way. It affects
food availability and security and may lead to rise of poverty as well. As a
natural calamity affects the agricultural sector, it leads to loss of income of
agriculture dependent households. This leads to default on agricultural loans
provided by banks, NBFCs etc. It also leads to lowering of loan rates and
increase in repayment duration to prevent the loans from becoming NPAs
(Non-Performing Assets). The financial sector can contribute is in

redistribution of wealth and prevent the effects of a calamity. Proper

allocation of resources are needed.

Role and Responsibilities of the Financial Sector

Two-Thirds of the losses due to climate change can be prevented by using
cost-effective measures. The financial sector including the government and
private organizations can have a greater responsibility for protecting the
climate. They can set up mechanisms which will prevent funding to
institutions which harm the environment in order to maximize profits.
Climate change being a long term phenomenon means that it is the
responsibility of these organizations to have a long term picture in mind
instead of running after short term profits. There is a tendency for individuals
and organizations to underweight climatic catastrophe and undermine its
effects on their businesses. This is one aspect where institutions need to
realize their roles and responsibilities towards future generations.

Steps for climate risk management

Financial institutions can set up products on the basis of how it affects the
climate. One such example is a Pay as you Drive car insurance, in which
drivers who travel high mileages have both a larger negative impact on the
environment and higher risk of accident. Group of financial institutions can
agree to incorporate environmental in their decision making process. They
can make their respective customers ply according to the guidelines which
would resolve the climate.
The current policy and approach emphasize on short-term, institutions can
change that. They can incorporate the effects of climate change in their
expected future cash flows. Increased risk of major disruptive climatic
events can be incorporated by including the cost of relevant insurance
premiums in cash flow projections. The long term effects can be incorporated
by simulations of alternative climate scenarios to determine the expected
cash flows. The arrival of new information may require a change in
investment strategies which can be utilized in the modelling, and thus place
a particular value on financial products which may allow for flexibility.
Governments can recognize their need to correct market failures. Effective
pricing policies, for example pricing the negative effects of greenhouse gas
emissions, policies for pricing carbon and for compulsory disclosure of
climate risks may allow the market to systematically and rationally respond
to threats of climate change.

Governments of developing countries are the ones under most pressure.

They can have policies which can help mitigate climate risk as well as
improve standard of living of their people. Financing by government and
corporate support to combat the effects of climate change can be delivered
to those who need it the most. For example, in Central America, the per
capita greenhouse gas emissions are less than 30% of those in industrialized
countries. Governments in the region have pledged to cut their emissions by
as much as 25% by 2030. In order to implement some measures to mitigate
and adapt to climate change they require investments of more than $4
billion a year whereas replacing the coffee trees with rust-resistant varieties
would cost an estimated $1 billion. Institutes like the Inter-American
Development Bank (IDB) have partnered along with corporate giants to
address the plight of the Central American farmer. The program provides
long term loans to the farmers. It also provides training in latest cultivation
methods and hence improve farmers with their yields.
Climate risk based financing, if can be shown to be successful and provide
greater return on investments than normal financial products, would also
encourage other nations and organizations to change their methods. Though
demand for finance in climate related projects is dispersed there are certain
areas where demand has risen. One of them is clean energy. More and more
focus is being laid on projects on renewable energy and energy efficiency.
China, one of the biggest consumers of oil has started a Green Bond which
will help small scale industries replace their tools with latest energy efficient
and environmental friendly equipment. The Government of Gujarat has spent
1000 crore rupees on the Bus Rapid Transit System (BRTS) which eased
traffic as well as reduced emissions drastically in the city of Ahmedabad.
The impact of climate change is something which will affect in the long term.
It is dependent on decision making and actions of finance providers. Since
there are uncertainties on the impact of climate change, we need to develop
a fact-based and long term climate risk mitigation system which can protect
communities from the wrath of natural calamities. Decision makers should
develop such a climate risk management system which not only balances
loss prevention and risk transfer, but also is focused on economic growth and
development.

References:
1. http://www.wri.org/our-work/project/world-resources-report/climatechange-adaptation-case-preventative-action-and-risk
2. https://www.project-syndicate.org/environment-sustainability
3. https://www.actuaries.org.uk/news-and-insights/media-centre/mediareleases-and-statements/risk-management-approach-essential
4. https://www.project-syndicate.org/commentary/coffee-rust-climatechange-finance-by-luis-alberto-moreno-2015-12#fVbBLMHtBsxas5wm.99
5. http://articles.economictimes.indiatimes.com/2013-0519/news/39355001_1_ahmedabad-brts-ahmedabad-municipal-transportservices-delhi-metro