Private financial firms in emerging markets and developing economies face specific challenges in developing green finance products and practices. These challenges reflect the characteristics of EMDE economies and financial sectors.
As a group, EMDEs tend to rely more than advanced economies on fossil fuels for domestic energy consumption. At the same time, many of them are heavily exposed to physical climate risk, while insurance coverage of this risk is low. As a result, these economies face higher hurdles in their energy transition.
Most EMDEs face substantial capacity and data gaps, especially in assessing climate-related exposures and risks. They also tend to have bank-dominated financial systems, shallow financial markets and a significant presence of foreign banks. These factors can influence the success of initiatives to introduce climate-related considerations in financial business decisions and, more broadly, the design of green and sustainable finance frameworks in these countries.
The characteristics of financial sectors in EMDEs are not always given due consideration by advanced economy policy-makers and transnational regulatory networks, whose initiatives largely shape the global regulatory environment. And even when advanced economy and EMDE regulators talk to each other, for example through the Network for Greening the Financial System, the concerns of the private sector do not always come to the forefront.
To address this gap, the International Finance Corporation has carried out a survey of private financial sector firms in emerging market and developing countries. The survey involved interviews with almost 60 participants from 29 private financial institutions in Bangladesh, Brazil, Colombia, Côte d’Ivoire, Egypt, Indonesia, Kenya, Mexico, Morocco, the Philippines, Poland, Serbia, South Africa, Turkey and Vietnam.
Four conclusions from the survey
First, the operating environment in EMDEs is fragmenting, with some financial firms coming under much greater pressure than others to incorporate climate-related considerations in their business. This pressure does not, as a rule, come from regulators, whose efforts in this area are still at a nascent stage, but from within the industry.
For foreign-owned subsidiaries or branches of financial firms from advanced economies, the parent company is the biggest source of pressure to meet climate and broader sustainability goals, often without regard to the conditions in the host country. Pressure also comes from development finance institutions in their capacity as investors or sources of financing. For insurance companies, the role of re-insurers is crucial. In contrast, pressures from civil society or domestic shareholders tend to be much less relevant in EMDEs.
This opens a rift between two types of financial firms. On one side are firms under pressure from parent companies, foreign investors, re-insurers or other stakeholders to green their activities. On the other are smaller, mainly local firms that are under little or no such pressure. The former is caught between a desire to move faster towards green finance and concern about losing market share. This produces an uneven playing field, creating a ‘first mover disadvantage’ that can hold back the adoption of green finance practices.
Second, although green and sustainable taxonomies are increasingly being introduced in EMDEs, they fall short of the principles required for effectiveness. They often have limited coverage (primarily energy generation, construction, agriculture and transportation) and are not sufficiently granular. They do not always specify the data required for assessing compliance or, when they do, the required data are not always available. The problem is worse in EMDEs that have imported a taxonomy developed in advanced economies without adapting it to domestic circumstances.
As a result, individual financial firms often have substantial leeway in assessing and reporting compliance with the taxonomy. The inevitable inconsistencies reduce the benefits of the taxonomy, create room for greenwashing and aggravate the unevenness of the competitive playing field.
Third, gaps in the regulatory environment in EMDEs pose a separate set of obstacles. Advanced economies have made progress in developing tools for assessing climate-related financial exposures and risks, although the experience has revealed several analytical and conceptual challenges. In most EMDEs, however, central banks and financial regulators lag their advanced economy counterparts in this area, mainly due to lack of data and expertise.
In several cases, regulators have recommended or required financial firms to disclose the environmental risk of their exposures without providing detailed guidance on how to do so. Even when guidance is provided, most respondents to the survey reported that it is too high-level, general or otherwise inadequate. As a result, individual firms are often left to their own devices in monitoring and managing these risks. The lack of a rigorous methodology and regulatory enforcement inevitably favours those firms applying less strict standards.
Fourth, private financial firms in EMDEs are aware that the move towards green finance entails both opportunities and risks. Some of the concerns expressed in the survey were similar to those in advanced economies. For example, given the scarcity of investable green projects, a rushed move towards green finance – in anticipation of or prompted by regulators – could create a severe demand-supply imbalance and fuel a ‘green bubble’. Other concerns were specific to the environment in EMDEs.
One of them was the risk of a sudden change in domestic regulations – perhaps under pressure from international standard-setters – to penalise certain exposures or encourage others, given the dearth of relevant and sufficiently granular data on which to base compliance. Another concern was adding to a regulatory agenda that is already overloaded in many EMDEs, notably with initiatives to encourage digital finance, micro-finance and financial inclusion. Adding another regulatory priority would not only increase compliance costs for financial firms but also stretch the resources of the supervisor.
But the biggest concern is the lack of an overarching long-term transition strategy by governments. Participants to the survey stressed that the goal should be to ‘green’ the whole economy, not just the financial system. Divesting from carbon-intensive assets and industries may help banks ‘green’ their balance sheets but would do little to aid the transition to net zero if incentives are not aligned, alternative assets and technologies are not available or various government policies are not coherent and consistent with each other.
It is the government’s responsibility to establish a transition strategy with realistic multi-year targets for economy-wide greenhouse gas emissions reductions, appropriate carbon tax and pricing policies consistent with these targets, national taxonomies with disclosure requirements for financial and non-financial companies and steps to generate and disseminate the data required to make these classifications and disclosures meaningful.
Only once such a strategy is credibly in place can the financial industry play its role in the long-term process of reallocation of capital needed to support the transition.
Dimitri G Demekas is an Adjunct Professor at the School of International and Public Affairs at Columbia University and Visiting Senior Fellow at the School of Public Policy at the London School of Economics.
Download the full survey and report from the IFC here.
These themes are further explored in the Sustainable Policy Institute Journal, Autumn 2023 edition.