Climate Change Opportunities and Threats in Microfinance (Part 1 of 2)
The impact of climate change on the poor
In these last decades, the debate surrounding the effects of climate change or global warming has become increasingly central to policymakers and business leaders. At its most basic, global warming refers to the increase in the average temperature of earth’s near-surface air and oceans. It is estimated that if no attempt is made to reduce greenhouse gas emissions, by 2100 global temperatures will increase between 1.1 and 6.4 degrees centigrade (IPCC, 2007).
This will have catastrophic consequences on the poor. Weather patterns will become more variable and unpredictable. The rise of sea levels will decrease the availability of water in regions that are home to more than one sixth of the world’s population, particularly those living in the mega-deltas of Asia and Africa. Additionally, there will be a higher incidence and severity of natural disasters, such as floods, cyclones and droughts. The warming of the earth will also change the geographical distribution of some infectious disease vectors and increase their incidence among humans, crops and livestock (IPCC, 2007).
Many of the world’s poor are directly dependent on the environmental ecosystem for their survival and wellbeing. Therefore these climate changes are expected to have the strongest impact on African, Asian and Latin American low-income populations. Declines in the productivity of major crops and livestock will adversely affect food security, thus resulting in higher chances and more extensive outbreaks of malnutrition. The rise in new infectious diseases and flood, drought, and heat-related deaths will also increase the number of people suffering from diarrhea, malaria, and other water-borne maladies.
As a result, the number of people in poverty and the severity of poverty will increase. By 2100, between 145 and 220 million additional people may fall below the $2-a-day poverty line (Stern, 2007). Climate change will also increase the variability of the income of the poor, heightening the chance that a shock will hit them.
The impact of climate change on microfinance institutions (MFIs)
Microfinance institutions (MFIs) offer loans, savings and insurance services to the poor helping them engage in productive activities, accumulate assets, stabilize their consumption and protect themselves against risk. This mission will become harder to accomplish in a sustainable manner (economically and socially) due to the effects of global warming.
Three out of four poor people in the world live in rural areas, and the majority of rural inhabitants depend on agriculture. In fact, most MFI customers are rural farmers. MFIs have in the last years refined their services to the rural population adding more sophisticated leasing loans for agricultural equipment and agricultural loans to their product portfolio (Dowla, 2004). Still, very little work has been done on adapting MFIs to climate change, in spite of the projected devastating effects on crop output of global warming. Average yields are expected to decrease due to temperature increases, water shortages and extreme events, such as floods and droughts. Climate change-induced increases in droughts, floods, and disease outbreak will increase the mortality of livestock, such as Bovine Tuberculosis and Rift Valley fever (WCS, 2008).
The negative impact on agriculture and livestock will be compounded by other harmful effects of climate change disasters in housing, health or local infrastructures, among others, and will arguably make living conditions much harder for MFI clients. MFIs will probably have to face an increase in default rates, a run on savings and increased claims on existing insurance products. This will result in lower and more volatile profits for MFIs as well. A sizeable portion of them may eventually go bankrupt. Additionally, as the consequences of climate change pile up on the poor, MFIs will be pressured to write-off the loans of the affected customers. This would have a negative effect on the culture of repayment that MFIs have built throughout the last decades and thus should be avoided. Finally, natural disasters might also have a direct impact on MFIs by potentially destroying partially or in total offices, equipment, information systems and customer records.
Grameen Bank provides an insight into the potentially disastrous consequences of natural disasters of MFIs. Bangladesh suffered floods in 1987 and 1988 and a tidal surge in 1991. However, the biggest natural disaster took place in 1998, when a flood inundated two-thirds of Bangladesh for 13 weeks. At Grameen, out of 2.3 million members at the time, about 1.2 million were affected by the flood. At the height of the crisis, 25% of its customers were in default. This caused huge liquidity problems on the bank which was only able to survive thanks to loans from commercial banks and the government (Dowla and Barua, 2006). Unfortunately, many other smaller MFIs were almost wiped out (Nayar and Faisal, 1999).
The CDM and voluntary carbon markets
Regardless of the negative impact of climate change on MFIs, these organizations are also uniquely positioned to palliate the negative impact of climate change on the poor. Unfortunately, the potential for financial services to alleviate the impact of global warming on the poor has received very little attention and remains mostly unexplored. MFIs can have such a strong impact thanks to their carefully built-networks within low income markets that give them access to the poor, especially women, as well as good quality information about their customers’ payment histories. Furthermore, the organizational structure of MFIs, based on high volume and small-sized transactions, is consistent with the myriad of adaptations required at the individual level to anticipate and palliate climate risks in the daily life of the poor.
How can MFIs adapt to climate change and help lighten the negative effects of climate change and natural disasters on their customers? In this post I will explain how MFIs can develop new financial services to encourage energy saving projects and profit from the growing market for carbon emissions.
MFIs are well placed to take advantage of the voluntary market for carbon offsets and carbon trading through the Clean Development Mechanism (CDM). The CDM was created in the Kyoto Protocol to promote clean energy development in developing countries. Reductions in the use of fossil fuels are then subtracted from a hypothetical baseline of emissions and can be sold to developed countries interested in balancing their excess emissions. As a result, developing countries can earn “emission reduction credits” by investing in projects that reduce greenhouse emissions. The size of the CDM market was estimated to be worth €12 billion in 2007 (IMF and WEO, 2008) and it has kept on growing since then.
CDM can thus provide an additional revenue stream to energy saving projects in MFIs, thus lowering the cost of introducing and expanding renewable energy and sustainable business practices in agriculture, forestry, and other sectors. Unfortunately, the current structure of the CDM is biased against small-scale projects due to the high transactions cost and lengthy bureaucratic procedures (on average 300 days) required to get energy projects validated under this scheme (Stern, 2008). While this approach is still relatively young, several organizations have already sprouted up to take advantage of this nascent market.
Nonetheless, it is clear that MFIs have a comparative advantage over other organizations in spearheading energy saving projects. ‘Green microfinance’ institutions are uniquely positioned to encourage energy-saving practices among their clients, because, as explained above, MFIs can tap into their existing network of clients to expand rapidly and generate economies of scale. Investing in clean energy will also have a positive effect on their customers’ health, safety and income. For instance, kerosene lamps, regular stoves, wood and cow dung are regularly used as fuel for cooking and lighting among poor households. However, the burning of these products also generates black carbon and small particulates which can ultimately cause respiratory illness and deaths and which increase air pollution (Ramanathan and Carmichael, 2008). The use of solar energy, clean stoves and biogas would reduce indoor pollution while being cheaper to employ – and, in the case of solar energy, might even be a source of revenue for the household if connected to the electric grid.
Under the CDM, MFIs can take advantage of the energy savings in these projects to earn emission reduction credits and use the revenue to fund their expansion or offer their services at lower prices. However, this option is available only to the biggest and most renowned MFIs. Smaller organizations will face difficulties in breaking into this market due to the high fixed costs imposed by the technical and financial requirements in the CDM. Since international financial institutions and foundations dedicated to microfinance such as the Grameen Foundation or the Bill and Melinda Gates Foundation are already helping MFIs launch green microfinance services, they could also act as intermediaries between the MFIs and the CDM by pooling energy saving projects among all partnering MFIs and by covering the fixed costs needed to participate.
Running parallel to the CDM market, a voluntary market for carbon offsets has emerged. Most MFIs seeking to profit from energy saving projects have chosen to sell their savings through this simpler route. The voluntary market consists of companies, governments and individuals who take responsibility for their carbon emissions and voluntarily purchase carbon offsets for their activities. Sometimes there is also an intermediary, a “retailer”, which invests in a portfolio of offset projects and subsequently sells smaller portions of the resulting emissions reductions to customers. The voluntary carbon market is free from stringent guidelines, lengthy paper work or high transaction costs (House of Commons Report, 2007). However, this simplicity has also been strongly criticized. Without a central verification and registration body, such as the one provided by the CDM, or a set of widely accepted and enforceable standards, it is difficult for credit emission buyers to assess the quality of the offsets being provided. Furthermore, this market has also been criticized on the grounds that it fails to provide enough information about the sellers or a more thorough analysis of the credit savings in the project (Taiyab, 2006). In spite of this credibility and information problems the voluntary market is growing rapidly.
From the point of view of climate change, this set of tools has an important weakness. Many green microfinance initiatives are solely designed to minimize the environmental footprint of low-income households. However, such initiatives need not reduce the negative impact of climate change or natural disasters on the poor. Therefore, MFIs offering these services often do not palliate any environmental shock or crisis suffered by the customers they service.
In my next posts I will explore two organizations which have developed different business models to generate both economic and social profits from this market opportunity.