No More Risky Business: How Latin America Can Stem Climate Risks in its Financial Regulatory Policy

By Maureen Heydt and Daniel M. Schydlowsky

The Latin American economy has been devastated by the COVID-19 pandemic, with the International Monetary Fund estimating that around 17 million people have fallen into poverty since the start of the crisis.

Beyond the COVID-19 crisis, Latin America’s economic growth and financial stability is also imperiled by climate risks, involving risk of socio-environmental conflicts, climate emergencies, and long-term climate change. Latin America must therefore contend simultaneously with recovering from the pandemic and addressing significant pre-existing risks.

How can Latin America best recover from the COVID-19 pandemic while addressing recurrent and new demands on   its financial regulations? What policy tools are available for financial regulators to do so, and how can they incorporate climate risks into Latin America’s financial regulatory policy moving forward?

The Boston University Global Development Policy Center recently convened a working group of experts, including Latin American bank regulators, development bankers, and related financial experts, to review the policy toolbox available to financial regulators and map a way forward, the results of which are summarized in a new report, written by GDP Center Distinguished Scholar Daniel M. Schydlowsky.

The Working Group submits that key to Latin America’s recovery from COVID-19 and to addressing the region´s climate risk is the internalization of externalities  as a major element of the region’s financial regulatory policy. To that end, it recommends financial regulators throughout the region adopt a compulsory Environmental and Social Risk Management (ESRM) system as part of their regulations. This will result in the inclusion and consideration of socio-environmental risks in the day-to-day management of financial institutions.

Originally developed for application to project finance and enshrined in the voluntary Equator Principles, the application of an ESRM system on a compulsory basis across the financial system, would ensure that any individual financier include in their evaluation the effect of a proposed project’s activities not only on the enterprise financed, but also on the area’s broader economic context. This includes considering the potential project impacts on workers, their families and communities, as well as the impacts on suppliers and customers and to make commitments for remedial action where socio-environmental harm can be anticipated.

The ESRM system operates through the management structure of financial institutions and broadens the spec­trum of risks that should be taken into account when considering issuing a loan. Furthermore, the system also establishes the need to not only identify the risks involved, but also to create a strategy to mitigate them as part of the respective proj­ect. The ESRM system does not require that projects with socio-environmental or climate risks not be financed, but rather that mechanisms be put in place to prevent, mitigate, or contain such risks and thereby reduce them as an integral part of the project itself.

Instituting an ESRM system is in the self-interest of financial institutions since neglecting impacts of financed enterprises on their broader environment means ignoring potential causes of their success or failure. However, competitive pressures as well as tradition leads each individual financing unit to narrow its view to the exclusion of the relevant externalities. Uniform, compulsory, regulation is the appropriate remedy and will produce a better result for the financial system as a whole. Any costs associated with the implementation of ESRM are more than offset by the resulting reduction of risk.

The ESRM system requires financial institutions ensure inclusion of the following in their project evaluation:

• A comprehensive description of the project to be financed.
• The ability of the enterprise financed to manage any likely socio-economic and socio-environmental chal­lenges posed by the project.
• Any environmental regulations applicable to the project.
• An evaluation of potential socio-economic and socio-environmental impacts, such as on air and water quality, on conflicts over land and water use, on sustainability of natural resource use, on involun­tary resettlement of populations, on effects on indigenous populations, and others.
• Plans for physical mitigation measures, for example, engineering works to counter landslides; incorporation of assurances of labor safety and health; inclusion of measures to control contaminating elements; and an outline of emergency response plans.
• Inclusion of mechanisms for participation and consultation of key and local stakeholders.
• Grievance mechanisms that are structured, effective and with verification of outcomes, and duly communi­cated in advance as part of the participation and consultation mechanism.

By incorporating an ESRM system, financial institutions can be sure projects and their organizers are qualified and prepared to address potential risks, either caused by the project or risks extraneous to the project that could impact it. This enhanced due diligence is important for individual financial institutions as well as the whole financial system, since socio-environmental risks tend to propagate and therefore can quickly contaminate portfolios within and across institutions. If the lender finds that the borrower lacks sufficient capacity to address potential risks, the Working Group recommends they undergo additional training or that financial institutions consider refusing the loan.

Along with implementing an ESRM system, the Working Group also recommends Latin America’s  Financial Regulators adopt specific policies for sectoral transformation, connectivity and financial inclusion, and building institutional social overhead capital. They further recommend regulations relating to contingency policies for natural disaster recovery and for business continuity in the face of natural disasters On policies to help recover economically from COVID-19, the Working Group, raises the possibility of using the recently implemented government guarantees as a lever to reduce interest rates to the smaller borrowers, recommends redefinition of ‘creditworthiness’ to take into account the interdependency of individuals´ ability to pay as everybody´s income recovers, and suggests that the governments of Latin America consider generating a special “national recovery bond” issue with an attractive interest rate to help finance the government’s COVID-19 response.

The Working Group also pointed to state-owned development banks as a second channel to embed environmental awareness and environment-friendly practices in the financial behavior of their clients, financial and corporate.

Coupled together, the adoption of an ESRM system and supporting, targeted, policy instruments would cumulate in financial regulation policies that can ensure the long-term soundness of the financial system and also contribute to the sustained evolution of Latin America’s economy on a path that is more consistent with environmental requirements and climate change.

The COVID-19 pandemic has created new challenges, while only temporarily obscuring the major preexisting ones: socio-environmental conflicts, climate emergencies and long-term climate change.  However, these challenges may not wait for the pandemic to be resolved to strike. According to the Working Group, emphasizing the internalization of externalities by adopting an ESRM system and additional supporting policies will help Latin America recover from the pandemic and better equip its economy to cope with future shocks and traumatic events.

This research has been funded by the International Network for Sustainable Financial Policy Insights, Research and Exchange (INSPIRE). INSPIRE is a global research stakeholder of the Network for Greening the Financial System (NGFS); it is philanthropically funded through the ClimateWorks Foundation and co-hosted by ClimateWorks and the Grantham Research Institute on Climate Change and the Environment at the London School of Economics.