Rethinking The Financial System Amidst Climate Externalities in The Gambia

Overview

Financial development is crucial for economic growth but can also serve as a double edge sword for the environment, as it contributes to both environmental quality and degradation by either exacerbating climate shocks via credit channels to eco-unfriendly industries or mitigating them by financing eco-friendly ventures.

Global sustainable finance is gaining momentum through initiatives like green bonds and eco-friendly finance departments in financial institutions, with green bonds market hitting to total lifetime of $2.5 trillion since its inception by the World Bank in 2008. However, relative to the $100 trillion size of global fixed-income market, the size of green bond market is still insipid but provides a remarkable opportunity for countries and institutions to leverage. Furthermore, in 2017, the Network for Greening the Financial System (NGFS) was established with 116 members composed of central banks and financial supervisory authorities. The NGFS is leading efforts to integrate climate-related financial risk into financial policies and regulations. However, despite the welcoming development, incorporating sustainable finance remains a challenge, particularly around "double materiality"—the idea that financial disclosures should cover both the impact of climate on businesses and the impact of businesses on climate (Joof and Adaoglu, 2024).

The Gambian Context: Why a Paradigm Shift?

The Gambia faces challenges in balancing economic growth with environmental sustainability. The financial system directs its credit to sectors like construction and agriculture, among others, but often without sufficient environmental safeguards.

My recent research revealed that two out of the six currency crises in The Gambia were due to climate-related shocks (drought). “The 2002-2003 currency crisis was driven by a severe drought that led to the collapse of the groundnut harvest, causing a 3% contraction in GDP and a dramatic depreciation of the dalasi by 45-60% against major currencies. This pattern continued with similar impacts from subsequent droughts, including the 2011-2012 drought, which caused a 4.1% GDP contraction and a nearly 30% depreciation of the dalasi against the US dollar" (Joof, 2024).

These events underscore the systemic risks posed by climate-induced shocks and the need for financial and economic policies that account for environmental vulnerabilities. Although the loan portfolios of the financial institutions might not be highly exposed to climate shocks, but a mere shock to the economy could have a devasting second order effect on the financial system.

Understanding the Risks: Physical and Transition Risks

Climate change presents two main risks to financial stability: physical and transition risks. Physical risks arise from direct climate impacts like natural disasters (droughts, floods etc.) which might damage infrastructure, and decrease agricultural yield. This in turn increases the insurance liability, default risk and decreases the profitability of corporations that rely on economic activities that depend on the ecosystem. And consequently, feedback into the financial system through non-performing loans, depreciated asset valuations, legal costs, and liquidity or via macroeconomic factors (shocks to exchange rates, and volatile commodity prices).

While transition risks stem from policy, technology, and consumer changes aimed at promoting the transition to a greener economy. Depending on the nature, speed, and focus of these changes, transition risks may pose varying levels of financial and reputational risk to companies. These can increase costs and reduce asset values, especially in sectors that are not sustainable.

Principles for Positive Finance and the Call for a Sustainable Shift

To address these climate-related financial risks, a shift in financial thinking is crucial. We must move away from focusing exclusively on financial returns, our approach should integrate three principles: (i) Combining financial, social, and environmental returns (ii) Setting sustainability goals (iii) Prioritize long-term societal value.

The Role of the Central Bank in Responsible Investments

The role of the Central Bank of The Gambia (CBG) in ensuring that financial institutions invest responsibly cannot be overemphasized. The CBG should implement regulations that encourage financial institutions to prioritize sustainable investments. This includes setting guidelines for environmental, social, and governance (ESG) considerations in lending practices and promoting transparency through mandatory climate risk disclosures. Furthermore, CBG should create incentives such as access to special funding facilities, interest rate subsidies and lower capital requirements for financial institutions that support green projects. By taking a proactive approach, the CBG spur a financial system that aligns with national sustainable development goals.

Towards Sustainable Finance: The Way Forward

Key steps for aligning The Gambia’s financial system with sustainable goals: (i) Encourage green bonds to fund sustainable infrastructure and projects (ii) Integrate Environmental, Social, and Governance (ESG) considerations into investment decisions to promote greener practices (iii) Enhance regulatory frameworks that Mandate climate risk disclosures to ensure transparency and proper risk pricing.

A Call to Action

We must rethink our financial practices and regulations to build a greener and resilient economy. A sustainable financial system is not just an option; it is essential for The Gambia's future. And CBG must steer this transformation by guiding banks toward responsible investments.

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