The IMF’s turn on climate change

By Kevin P. Gallagher, Professor and Director of the Global Development Policy Centre at Boston University’s Pardee School of Global Studies, and Co-Chair of the ‘Think 20’ Task Force on International Finance to the G20

The International Monetary Fund (IMF) has recently pledged to put climate change at the heart of its work. A laggard to date, the IMF has to catch up fast to ensure that the world community can meet its climate change and development goals in a manner that doesn’t bring havoc to the global financial system. The IMF’s first test on climate change will be the extent to which it incorporates climate risk into this year’s reform of IMF surveillance activities. Given that these reforms will lock in for close to a decade, if the IMF doesn’t act now the consequences for prosperity and the planet will be grave.

Kristalina Georgieva has been a strong advocate of greening the financial system through her new post of Managing Director of the IMF, which she began in the fall of October 2019.  Unfortunately, she took office when the shareholder of the IMF with the most voting power, the United States, was led by a President who claimed climate change was a hoax. In the face of that pressure and to her credit, Georgieva steadfastly advocated for incorporating climate change into IMF operations and for a green recovery from the COVID-19 crisis even though her biggest patron made it difficult to put her words into action.

“Pioneering central banks have taken this to heart and now recognise that climate change equally poses two types of macro-critical risks to financial systems: ‘physical risk’ and ‘transition risk’.” #DevMatters

What a difference an election makes. In January this year President Joseph Biden issued a game changing Executive Order declaring that the United States Treasury shall deploy its voting power at the IMF and other international financial institutions “to promote financing programmes, economic stimulus packages, and debt relief initiatives that are aligned with and support the goals of the Paris Agreement. 

To reach our shared climate and development goals nations of the world need to mobilise an additional 2.2 percent of GDP on an annual basis until 2030. This effort effectively amounts to stepwise investments in renewable energy, green industry, sustainable infrastructure, and a decommissioning of fossil fuel energy and associated economic activity. Alongside those investments are adjustment investments and support necessary to ensure that no worker, community, entrepreneur, and whole country gets left behind. This, while coping with the costs of climate change that are already inflicted upon our economies in the form of increased drought, hurricanes, floods, and other extreme weather events.

By definition a just transition to a 21st century world economy that is sustainable and inclusive will be disruptive to financial and fiscal systems alike. In recent years, pioneering central banks have taken this to heart and now recognise that climate change equally poses two types of macro-critical risks to financial systems: ‘physical risk’ and ‘transition risk’. 

Physical risks occur when the material effects of climate change, such as increased incidence of hurricanes, damage physical assets, subsequently damaging balance of payments positions, increasing credit risk, and incurring financial losses for investors that can ripple to damage economies and livelihoods. The World Bank estimates that climate related natural disasters cost developing countries upwards of $520 billion and force 26 million into poverty each year. 

“It is imperative that the IMF recognises that physical and transition risks are both equally macro-critical to financial systems and that assessments of such climate risks are mainstreamed in all surveillance and subsequent advice activities.” #DevMatters

Transition risks emerge from a late and uncoordinated introduction of climate policies whose impacts cannot be fully anticipated by investors—say a sudden ban on coal-fired power plants–leading to sudden adjustments of asset prices. Many central banks have organised a Network for Greening the Financial System (NGFS) and now perform regular ‘stress tests’ on the extent to which shocks from physical or transition risk impact finance and banking in their countries. 

Thus far, the IMF has been blind to this kind of climate risk surveillance.  Since 2017, the IMF has conducted and published 384 Article IV reports and 66 Financial Sector Assessment Programmes (FSAPs)—the IMF’s two major tools for performing surveillance in member crises.  According to new research at our Global Development Policy Centre, during that time the IMF only mentioned physical or transition risk a handful of times.  When the IMF did discuss those risks, they did so very inconsistently. Research by the European think-tank Recourse has shown that on the one hand the IMF acknowledged the shortcomings of coal dependency in Mongolia, only to later recommend better investment incentives for the country’s coal deposits to pick up growth.

A key type of transition risk that only the IMF has the purview to tackle are ‘spillover transition risks.’ The IMF is tasked with looking at potential financial risks that are triggered when the actions of one country impact the financial system of another—referred to as ‘spillovers’. Applied to climate risk, this means when large markets make quick transitions away from fossil fuels—say an EU carbon tax—that could shock the balance of payments, sovereign credit, fiscal balances, and more in major fossil fuel export economies. Take Nigeria for example where an EU carbon tax with border adjustments could be quite a shock as oil is the principal export, means of foreign exchange, and fiscal revenue of the country. 

Although the IMF has paid scant attention to these issues, especially the countries that face the most risk, it has begun to experiment with these approaches.  Beginning in 2017 the IMF piloted six ‘Climate Change Policy Assessments’ for small countries vulnerable to physical risk in Seychelles, St. Lucia, Belize, Grenada, Micronesia, and Tonga. Last year the IMF piloted a transition risk assessment that looked at both national level and spillover transition risk channels in Norway.

The IMF has shown that it has the capability to conduct such surveillance and now has the political backing from major shareholders and leadership.  It is imperative that the IMF recognises that physical and transition risks are both equally macro-critical to financial systems and that assessments of such climate risks are mainstreamed in all surveillance and subsequent advice activities. The IMF is the only global institution tasked with preventing and mitigating financial instability, and is thus our only hope.