Finance has become a key arena for climate action in recent years. The reason is that it is not just fossil fuel producers and users who are responsible for greenhouse gas (GHG) emissions. Institutions that provide finance to them are also being held responsible for emissions and the resulting impact on the climate. At the same time, changes in the climate can affect the profitability (or even the financial sustainability) of the companies that are clients of financial institutions, thus increasing the risk in a lender’s portfolio.
These two impacts––the impact of loans on the climate and the impact of the climate on the quality of the loan portfolio––is called “double materiality”, and it is at the heart of emerging regulatory reporting requirements for sustainable finance. For example, the European Union (EU) used the double materiality framework when it adopted its regulations on sustainability‐related disclosures in the financial services sector, which became effective in March 2021.
All lending is risky, and “double materiality” means that the effects of climate change increases risk to a lender in two ways. Institutional (i.e., portfolio) risk increases because climate change can adversely affect the ability of clients to repay their loans. This is particularly true regarding loans for agriculture and rural enterprises in developing countries, where agriculture, livestock and fishery value chains are underdeveloped. This has physical and institutional causes, including:
- Poor quality of rural roads and high cost of farm-to-market transportation
- Deficit of markets, stores, warehouses, cold stores, and larger agro-processing infrastructure facilities, including special economic zone and agro-processing clusters
- A “missing middle” in the agribusiness distribution network—specifically, there are relatively few small and medium-sized enterprises (SMEs), and those that do exist have limited capacity (in terms of access to information, technical and business skills, and finance) and have to deal with a weak legislative investment framework
- Underdeveloped farmer and producer organizations (especially agricultural cooperatives for inputs and machinery supply and outputs marketing) and immature contract farming arrangements
- Inadequate food safety legislation and enforcement, and absence of safety and traceability mechanisms
These factors result in insufficient food production, low yields, high rates of loss and spoilage, and missed opportunities for growth. These factors weaken food security, decrease natural capital and increase climate vulnerability. Therefore, one of the urgent tasks of financial institutions that lend for agriculture and rural business is to analyze the environmental and vulnerability risks in their portfolios.
The second source of risk derives from the fact that a financial institution’s loans could contribute to climate change. The most important factor, especially in Southeast Asia, is when forests or other land is developed for farming (known as forestry and other land use––FOLU). For example, with regard to agriculture financing, the European Union requires that loans cannot be made for agricultural activities that are carried out on land that was previously deemed to be of “high carbon stock”.
Even without deforestation, in many countries (also especially in Southeast Asia), agriculture is the second largest contributor to climate change after the energy sector. Moreover, this contribution comes from more than GHG emissions. Even if a country’s farmers use little petroleum-derived fertilizer, rice cultivation and livestock raising emit large amounts of non-GHG emissions.
Addressing these kinds of risks requires a different approach to risk monitoring and management. Even those financial institutions with strong risk management systems are unlikely to be collecting information about and monitoring information about these risks, much less have policies in place to mitigate them. Most financial institutions need to develop an environmental and social risk management (ESRM) system to identify, categorize, assess, analyze and monitor the direct and indirect environmental impact of their clients’ activities that result from their loans. This system is needed not only for a financial institution to understand the environmental risk and impact of their lending activities but also to report to their stakeholders and to climate funds to justify the wholesale loans they receive from them.
Also, since most of the international funding for climate-related finance comes from countries and funds that are adopting the double materiality disclosure standard, such as the Global Climate Fund (GCF), those funds will also impose similar requirements on their borrowers. Any financial institution that wants to venture further into green finance with such funding will be required to adopt similar reporting practices.