Changing climate for investment in Nepal

Banks are exposed to a complex risk environment because of the climate crisis the world over. With their diverse asset class portfolios across multiple sectors, banks are vulnerable to new risks involving loan portfolios, investments, and business operations. 

Banks need proactive approaches to plan transitions to a more resilient and sustainable future, while analysing the immediate effects of climate disasters. Developing appropriate methods to manage these risks while trying to remain competitive should be the priority of all banks.

Banks in Nepal face both transitional and physical risks because of the impact of climate change.  They must evaluate how these hazards may interact and intensify, since the risk factors are interrelated.

The direct impact of climate breakdown on a bank’s assets and operations are referred to as physical risk, which are the tangible, real-world effects of severe weather, increasing sea levels, temperature fluctuations, and other climate-related phenomena. 

One example of these risks is the possibility of property damage from extreme weather events, floods or wildfires, which can destroy buildings, infrastructure, and businesses. Disruptions in the supply chain can also result in the scarcity of products and services, which is another kind of physical risk. 

Physical risks can be acute or chronic. Event-driven risks such as typhoons and floods can be called acute risks, whereas the long-term shift in climate patterns are chronic physical risks.

Transitional risks, on the other hand, would be the financial burden associated with the shift to a low-carbon economy with concurrent changes in consumer behaviour, market sentiment, regulatory changes, and technical breakthroughs. New policies by governments and regulatory agencies to address climate change, carbon pricing, or tighter environmental standards can impact the economy and the banking sector.

A few commonly used frameworks to reduce the climate risk of banks are:

· Task Force on Climate-related Financial Disclosures (TCFD) which was articulated by the Switzerland-based Financial Stability Board in 2015. In 2017, TCFD released a report with 11 voluntary recommendations for disclosing climate-related financial risks and opportunities. It is made up of four pillars: governance, strategy, risk management, and metrics and targets. 

·  Principles for Responsible Banking (PRB) were developed by the United Nations Environment Program (UNEP) Finance Initiative. PRBs have been signed by over 300 banks from 60 countries since 2019 and are based on six guiding principles: Alignment, Impact and Target Setting, Clients and Customers, Stakeholders, Governance and Culture, Transparency and Accountability. PRBs aim to align the banking sector with the Paris Agreement and SDGs. 

· Equator Principles (EP) are a voluntary risk management framework developed by the International Finance Corporation (IFC). Financial institutions adopt 10 EPs to determine, assess, and manage environmental and social risk in project finance transactions. Financial Institutions that adopt the Equator Principles commit to implementing them in their internal environmental and social policies, procedures, and standards for financing projects as well as to restrict new finance or corporate loans to projects where the client is unable to comply with the principles.

· The Carbon Pricing Leadership Coalition (CPLC) was developed by the World Bank as a voluntary initiative that brings together leaders from governments, business, civil society, and academia to enhance global understanding of carbon pricing as a tool for accelerating and financing effective climate action.

·  Climate Resilience Principles (CRP) were developed by the Climate Bonds Initiative to integrate the criteria for climate adaptation and resilience into the climate bond standard. CRP guides financial institutions and other stakeholders on the potential range and type of climate resilience investments, ways to define and assess physical risks, and approaches to demonstrate climate resilience outcomes credibly. 

· The Joint Impact Model (JIM) as a useful tool to navigate challenges in reduction in carbon footprints. By the quantification of emissions linked to their loan portfolios, institutions can obtain vital insights into their climate effect and pinpoint opportunities for finding ways to be supportive of the circular economy.

Banks can also employ technical and financial tools to minimise both physical and transitional risks and these can help quantify potential impacts, allowing informed decision-making and risk management using Climate Scenario and Extreme Event Analysis. Geospatial Risk Mapping can be used to assess hazardous zones. Hydrodynamic modeling is a tool to simulate effects of flooding. Carbon Footprint Calculations can help banks assess lending portfolios.

Testing can be conducted to evaluate the impact of a transition to a low-carbon economy on the bank’s financial performance, considering changes in market dynamics, asset values, and investment returns. Environmental, Social, and Governance (ESG) factors can be included into financial models to evaluate the long-term sustainability. 

Financial modeling adopted by banks for climate risk mitigation is diverse, encompassing various aspects of physical risks and Transition Risk. Data Collection and assessment of historical weather patterns, and projections for property location, exposure to flood zones, and susceptibility to extreme weather events can help banks identify potential physical risks. 

Scenario Analyses can be developed to simulate various climate change scenarios and their potential impacts on assets and borrowers. Insurance and Risk Transfer Instruments can be used to explore the use of insurance products and risk transfer instruments to mitigate the financial impact of climate-related physical risks. Sustainable Finance Product Modeling helps the bank to develop financial models for sustainable finance products, such as green bonds or sustainable loans, to assess their risk-return profiles and market viability. 

Nepal’s banking industry faces challenges to safeguard credit portfolios. Banks should adopt a consensus approach to navigate transition and physical risks. Nepal’s banks are already seeing climate impacts on their loan portfolios.

Agriculture

Farms are affected by erratic rains. Floods destroy infrastructure and crops, lowering productivity and impacting the ability of borrowers to repay loans. The Kosi Flood in 2008 was one of the most destructive. In the past decade alone, some 300,000 hectares of farmland have been lost to floods. Last year, 325,258  tons of harvested paddy worth Rs 8.26 billion were destroyed. 

Banks must support smart irrigation systems that enable farmers to modify watering schedules based on real-time meteorological data to help conserve water and reduce the effects of shifting precipitation patterns and glacial melt.

EVs

Electric vehicles are becoming more popular among consumers. Banks need to adjust financing in response to this spike in demand for EVs and providing loans for charging stations. In the first 11 months of the fiscal year 2022–2023, EV imports totalled 3,070 valued at Rs 11.23 billion, a 122% increase over the same period in the previous fiscal year. AT this rate, EVs will fully replace petrol cars.

Hydropower

Change in hydrology of rivers, reduced water availability during dry seasons and changes in precipitation patterns can all have an immediate effect on hydroelectric plants. The increase in the frequency and severity of extreme weather have damaged hydropower schemes. Floods on 16-17 June 2023, in eastern Nepal damaged 30 hydropower facilities with a combined capacity of 463 MW. The hydropower sector is also exposed to transition risks, including carbon pricing, emissions limits, and renewable energy generation.

Manufacturing 

Changes in regulatory policies, such as carbon pricing, emissions limits, and renewable energy mandates, that aim to address climate change may also result in greater compliance and operational costs for manufacturing firms. If clean energy and sustainable manufacturing practices render conventional manufacturing methods less competitive or obsolete, adoption and investment in new technologies and processes may become imperative. Infrastructure related to manufacturing projects could also be physically damaged by storms, floods, and other natural disasters, as well as it could have a serious impact due to severe weather patterns. 

As a first step toward mitigation, banks should thoroughly assess the climate risk associated with manufacturing projects and their clients. Banks should also provide financing and investment products that are specifically designed to support climate-resilient and sustainable manufacturing practices. Examples include green loans, which can be combined with advisory services, technical assistance, and capacity building project support to assist clients in identifying, evaluating, and putting into practice strategies for waste management, water conservation, renewable energy integration, and energy efficiency.

Govind Ghimire is the Deputy CEO of NMB Bank.