Climate risks in Latin America and the Caribbean: Are banks ready for the green transition?

Climate change is increasingly making its mark in Latin America and the Caribbean. Caribbean countries are among the most exposed in the world to extreme weather events, such as hurricanes and floods, while the impact of climate change is ever more visible in Central and South America. Already hot areas, small island states and countries where climate-sensitive sectors (especially agriculture) play a large role in the economy are being disproportionately affected.

­­­Despite contributing less than 5% of global carbon emissions, the countries in the region have been hit with as many as 1 350 natural disasters attributable to climate change, affecting more than 170 million people and causing almost 30 000 deaths over the past two decades. The economic damage associated with these events is estimated to be over $170 billion.

The damage caused by extreme events represents only part of climate change’s toll, while the costs associated to “chronic” risk, connected with the gradual long-term impact of global warming, are also relevant. And part of the overall climate risk is also related to transition risk, which stems from policies aimed at achieving a lower-carbon economy (e.g. phasing out local coal industry).

Each banking sector is directly affected by country-level climate risks, but the magnitude of these risks is influenced by its exposure to different economic sectors, such as agriculture, mining, manufacturing and tourism. Banks in the region remain sound and profitable and capable of supporting the transition, but there are significant differences across countries.

Despite the significant needs, Latin America and the Caribbean countries receive a relatively small share of global climate finance. The international financial community and public development banks have an important role to play to support both public and private green investments providing long-term, patient funding at affordable rates and sharing part of the risks.

Economic impact of physical risk in the world, by component (world average = 1)

Climate change poses direct physical risks to people, businesses and infrastructure, sometimes via extreme weather events sometimes more gradually, for instance on account of worsening conditions for agriculture, the rise in sea levels, the degradation of infrastructure, increased water scarcity and decline in labour productivity.

• Latin American and Caribbean countries witnessing increasingly high temperatures are more exposed to such risks.
• The Bank’s analysis shows that physical risks are most pronounced in agriculture and mining, exposed to weather conditions. Out of the total impact of physical climate risk (given by the sum of extreme events and chronic impacts),  "chronic risk” is estimated to represent between 30% and 80%, depending on the country.

Regarding the financial sector, banks in the Caribbean, are more exposed to physical risk. The smaller islands are subject to extreme events and their economies – governments, corporates and households – are significantly affected, while banks’ lending to high-risk sectors is relevant.

Aggregate banking sector exposure to physical risks, by sector

High emitting countries are generally more exposed to transition risk than developing countries; however, Latin America and Caribbean countries also face relevant transition risks stemming from the need to reduce greenhouse gas emissions.

• National policies to reduce emissions can intensify some risks, hurting businesses by increasing energy costs or through additional taxation for carbon emissions or programmes to cap emissions.
• Another source of risk is the lowering of the market value of certain assets, such as factories or power stations, that are heavily emitters. Developing countries have often lower mitigation capacities, in terms of energy efficiency and likelihood to deploy renewables.

Regarding transition risk in the region, the EIB’s analysis shows that transition risk is less pressing than physical risk for banks in Latin America and Caribbean, but some countries are significantly exposed.

• Transition risks are highest in the mining (related to coal, gas and oil) and tourism sector (potentially affected by aviation, which is carbon-intensive).
• Transition risks are higher in the Caribbean, followed by Latin America, due to the exposure of banks to the sectors more exposed to such risk, especially tourism and mining.

Aggregate banking sector exposure to transition risks, by sector

Capital flows for climate projects in the Latin America and the Caribbean region have been lagging other regions, particularly given the need to overcome physical risks in Caribbean countries.

Countries in the region received around 6% of the total share of global climate finance in 2019 and 2020, lagging  East Asia and the Pacific that dominates climate finance, followed by Western Europe and North America.

• Despite facing a complex macroeconomic juncture, banks in Latin America and the Caribbean are remarkably sound and profitable, although there are notable differences across countries.
• Banking sectors in the region seem to be diversifying their loan books away from the most climate-exposed sectors paired with having low shares of NPLs.
• However, financial depth in the LAC remains low compared to income peers and so does the flow of capital for climate projects.
• To stimulate climate investment, international financial institutions and public development banks can support public and private investments by providing long-term funding at affordable rates and by offering technical assistance and instruments to reduce risk.

Climate flows in different regions (percent of total 2019 and 2020 investment flows)