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Climate-Related Financial Risks for Kenyan Banks

Reuben Muhindi Wambui

2. Literature review

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1Financial markets are not shielded from the ever-increasing effects of climate change. Climate change presents significant risks for financial institutions in terms of investments, lending, risk management, and insurance underwriting, with these risks having broader implications for the stability of the financial system (Global Risk Institute, 2016). Climate-related risks are typically classified into two primary channels: physical risks and transition risk. Physical risks result from climate and weather-related events which could result in large economic costs and financial losses, including asset impairment. Transition risk relates to the process of adjusting to a low-carbon economy, including losses arising from government policies, such as carbon taxes, and financial losses in high-carbon sectors resulting from rapid uptake of low-carbon new technologies (Feyen et al., 2020).

2Responses to climate issues have tended to focus on energy policy and carbon pricing policies (International Monetary Fund, 2019), including pricing policies that not only reflect environmental costs but also co-benefits of innovation and increased productivity growth (Aghion et al., 2009). There has been a consistent push for market-based solutions to tackle climate change and facilitate low-carbon transition. Nonetheless, a number of market failures, such as the free-rider problem and imperfect information, limit effective response to climate risks. It is also recognised that fiscal policies and markets by themselves are not sufficient, justifying the use of climate-relevant financial polices (Krogstrup & Oman, 2019). Such policies are sometimes complicated by political factors because economic groups that stand to benefit from the status quo often lobby governments against policy action to correct market inefficiencies.

3Incomplete and imperfect capital markets constitute one key market failure that makes it difficult to measure the climate risk exposure of different financial assets and to factor in this risk in asset pricing. One recommended solution to incomplete information is requiring climate-related disclosures by financial actors with the aim of improving the pricing and transparency of climate risks in financial assets. However, a key limitation in making disclosures is lack of quantifiable, relevant, and decision-useful information on climate risk exposure that is comparable among different financial actors (Monasterolo et al., 2017). In instances where information is available, there is the challenge of defining the materiality of climate risk and determining how to incorporate climate scenario analysis as part of the disclosures (Climate Disclosures Standard Board, 2017).

4Climate-relevant information allows for estimating climate risks and their impact on the stability of the financial system (Battiston et al., 2017). Much of the literature has built on Integrated Assessment Models (IAMs) with the Dynamic Integrated Climate-Economy (DICE) model (Nordhaus, 1992, 2014) considered a benchmark from which many modifications have followed. Nonetheless, modeling climate change risks remains a challenge given that climate change affects the economy through multiple channels interacting with each other in multiple ways (Schneider, 1997). Dietz et al. (2016) used an approach that builds on IAMs to calculate the Value at Risk (VaR) induced by climate risk while some previous literature has focused on the calculation of potential stranded assets emanating from climate risk (Meinshausen et al., 2009). Within the existing literature, there is no consensus on the best methodologies for estimating climate risks and traditional models have been insufficient to capture the climate risk associated with specific financial actors or asset classes.

5In response to the need for climate risk assessment and quantification that facilitates relevant and decision-useful climate-related disclosures, novel approaches have been proposed on how to identify, assess, and monitor climate risks. Monasterolo et al. (2017) analysed the exposure of investors’ portfolios to climate risks using a data-set of financial actors’ equity holdings and loan portfolios for 17 euro-area countries in 2014 and proposed two new and complementary indices,

6“GHG exposure” and “GHG holding”. My research adapts this novel approach for climate-risk assessment of financial actors by constructing Emissions Exposure (EEi) and Emissions Funding (EFi) indices for Kenyan banks. The focus on the financial sector is important for three reasons: 1) it allows for assessing the direct exposures of financial actors to climate risks; 2) climate risks affect sectors in the real economy and consequently this has a direct effect on financial actors’ lending or investments in these sectors (Battiston et al., 2017); and 3) the financial sector plays a key role in capital allocation within the economy and thus has a key role in accelerating the low-carbon transition.

7Climate-related disclosure requirements facilitate market pricing that is reflective of the cost of climate risks inherent in different asset classes. Further, this transparency and associated price correction would incentivise market actors to reallocate capital from climate-risky assets to low-carbon investments within their portfolios. Thus the two climate-relevant indices that are the primary output of this study would facilitate quantitative and comparable climate-related disclosures across Kenyan banks. In effect, this study advances the objective of quantifying climate risk and its implications for systemic risk within the financial system. Quantifying climate risks is a rational pre-requisite to the designing of feasible climate finance policies (Carney, 2015; European Systemic Risk Board, 2016).

8To my knowledge, this is the first research in Kenya and across African markets that provides a set of quantitative and comparable climate-related disclosures for banks that directly links the sectoral composition of bank lending portfolios to national GHG emissions to establish the climate risk exposure represented by banks’ portfolios and their relative funding of the climate risk through their lending. The findings provide decision-useful information for the CBK and the government on climate-related financial risk and has implications for climate financial policies that would seek to promote financial stability and facilitate smooth transition to a low-carbon economy. Further, this analysis provides a template for other emerging economies for the assessment of banking portfolios for climate-related financial risk using the two indices.


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