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2020s Vision: Climate change to reshape developing country finance

    Stuart Culverhouse
    Stuart Culverhouse

    Chief Economist & Head of Fixed Income Research

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    Tellimer Research
    11 December 2019
    Published byTellimer Research

    Awareness turns to action… hopefully

    If 2019 was something of a watershed in terms of climate change awareness, the next decade will be pivotal in terms of climate action. That is because scientists and many policymakers say we are a long way from meeting the internationally agreed climate target of a 2°C increase in global temperatures (above pre-industrial levels), as specified in the 2015 Paris Climate accord, let alone the aspirational target of a 1.5°C increase.

    The latter target means halving greenhouse gas (GHG) emissions by 2030, and achieving net zero emissions (carbon neutrality) by 2050. Instead, on current trends, global temperatures could increase by 4°C by the end of this century (with a catastrophic impact on sea levels, among other effects, as Rahul Shah discusses in our "Rising oceans, shrinking land" theme).

    Developing countries are often hardest hit

    Particularly at risk from climate change are low income (developing) countries, which tend to be more dependent on agriculture and tourism for livelihoods, small island states, and low-lying countries and coastal areas, at risk from rising sea levels and incidents of hurricanes and tropical storms. Disruption to food supply, poverty, displaced peoples and mass migration will challenge the global economy.

    And those developing countries that have hitherto relied on fossil fuel exports will also be greatly affected by changes in energy use as societies switch to cleaner energy sources (renewables). Those that have accumulated savings and/or made greater efforts to diversify their economies may be better able to withstand such a transition.

    And it will increasingly affect international finance

    Climate change has risen up the global policy agenda in the world of international finance, whether in terms of fiscal policy (creating fiscal space for fighting climate change, devising social safety nets to protect the most vulnerable and the role of carbon taxes), how monetary policy should respond to climate change, the impact on financial sector stability and the insurance market, and new growth models and diversification strategies (for example, built around the circular economy).

    Indeed, developing countries, such as the Seychelles (pioneering the blue economy), the Caribbean (through the regional pooled insurance market, CCRIF) and other small island states, are leading the field in financial innovation and advancing global policy.

    Specifically, we highlight four areas where climate change could have an impact on developing country finance:

    1. Incorporating climate change into risk and ratings assessments, and pricing climate risk. We think climate risks will become more systematically integrated into ratings assessments, as for instance Moody’s and Fitch have stated (the latter through its ESG Relevance scores). This may have positive or negative effects, depending on the extent of climate vulnerability, policy space and climate resilience, so it may not automatically imply a higher probability of default (or loss-given-default). But if it does, how will this impact sources of finance and borrowing costs, especially for LICs?

    2. Impact of climate change on IMF lending and surveillance. We expect climate change to become more fully integrated into usual macro surveillance and IMF lending programmes, especially for low-income and climate-vulnerable countries, under the new Managing Director, Kristalina Georgieva. This might see an extension of the IMFs existing Climate Change Policy Assessments (CCPAs) and other work on small states. Meanwhile, the Fund’s existing albeit low access crisis-related facilities may be insufficient in an era of more frequent and/or severe natural disasters and require the design of new instruments for climate-related economic crises.

    3. Climate finance. Developing countries will have to spend much more on climate change adaption and mitigation, and managing transition risks. How will this be financed, and by whom? For instance, advanced economies agreed under the Paris Agreement to mobilise US$100bn a year from public and private sources for climate projects, from 2020 onwards (the UN-supported Green Climate Fund announced on 25 October funding pledges of US$9.8bn). However, donors will not be providing all the money, and some is conditional on governance reforms anyway, which could imply funding shortfalls. Some countries have been able to take advantage of financial innovation through issuing green and blue bonds, although these tend to be smaller in nature, more fragmented and less liquid issues than traditional sovereign bond markets.

    4. Inclusion of climate-disaster clauses in sovereign debt contracts. Two countries (Grenada and Barbados) have specific clauses in their foreign bonds that provide debt service relief under certain circumstances of weather-related shocks (so-called “hurricane clauses”), and both of these came out of restructurings. It might only be a matter of time before such clauses are included in primary issues, especially among LIC issuers. There is a first-mover problem, reminiscent of the inclusion of collective action clauses (CACs) in NY law bonds in 2003, amid potential fears that such clauses will raise the cost of borrowing for the issuer, but we think such adoption – su itably designed and communicated – would see widespread support (and, based on the two examples so far, the pricing impact appears minimal). Of course, however, it will take a long time for EM issuer bond stocks to reflect this innovation. And others might think the catastrophe insurance market is a more efficient way of dealing with these risks rather than through bond clauses.

    Read our full 2020s Vision: 20 themes for the next decade report.