"Climate change is the Tragedy of the Horizon. We don’t need an army of actuaries to tell us that the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix." – Carney, 2015

1Climate change is one of the most defining issues of the century that presents a direct existential threat (Guterres, 2018). Traditionally, central bankers did not wade into the climate debate since climate change effects were long considered an externality rather than a pertinent issue within the purview of financial regulation. There has however been a shift globally as central banks and other market authorities have begun to take a keen interest in climate change and low-carbon transition.

2The push for financial institutions and regulators to consider climate risk has mostly occurred in advanced economies. For example, the EU developed the Sustainable Finance Taxonomy and the UK Climate Financial Risk Forum, jointly established by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA), recently published guidance for banks and insurers to analyse the impact of climate risks on their operations (Climate Financial Risk Forum, 2020; European Commission, 2020). In spite of the progress made in advanced markets, climate change poses a risk to financial stability in emerging economies like Kenya. Often, this risk is actually disproportionate given the materiality of the climate risk exposure relative to the low levels of greenhouse gas (GHG) emissions in many of these countries. Diffenbaugh and Burke (2019) found that global warming has increased global economic inequality between developed and developing nations by 25% since 1960 and this is associated with historical disparities in energy consumption.

3There have been multiple industry-led initiatives that seek to explore climate risks and opportunities, including facilitating climate-relevant disclosures by financial institutions. Globally, a notable initiative has been the recommendations by the Task Force on Climate-related Financial Disclosures (TCFD). Within banking, there have been sustainability initiatives such as the Network for Greening the Financial System (NGFS), the Sustainable Banking Network (SBN), and the Principles for Responsible Banking by the UNEP Finance Initiative (UNEP FI).

4Given the key role of banks in allocating capital within productive sectors of the economy, it is imperative for individual banks and financial regulators like the Central Bank of Kenya (CBK) to actively contribute to climate change mitigation and adaptation for the transition to a low-carbon economy. This includes harnessing green capital and promoting low-carbon investments. Specific to Kenya, one industry initiative has been the adoption of Sustainable Finance Initiative (SFI) Guiding Principles developed by the Kenya Bankers Association (2015) to promote inclusive growth. Banks have also adopted risk management strategies in their credit appraisal processes to analyse loans using environmental, social, and governance (ESG) metrics.

5However, there is an unexploited opportunity at the industry level to quantify climate risks attributable to GHG emissions through banks’ lending activities and using such risk metrics to facilitate climate-related financial disclosures that are easily comparable across banks and that are decision-useful for climate policy and regulation. This research seeks to explore and fill this gap.

6In this study, I analyse the exposure of Kenyan banks’ lending portfolios to climate risk and their relative funding of this risk given the GHG emissions represented by their portfolios. This is achieved by constructing two climate-relevant indices for banks: an Emissions Exposure Index (EE_i) and an Emissions Funding Index (EF_i). The first, EE_i, is a measure of a bank’s portfolio climate risk exposure given the GHG emissions represented by its loan portfolio through its sectoral loan composition. The second, EF_i, is a measure of the climate risk funded by a bank through its lending relative to other banks and is thus a measure of climate risk importance with regard to each bank. This approach is an adaptation of the methodology used by Monasterolo et al. (2017) to construct “GHG exposure” and “GHG holding” indices. These authors were the first to propose such complementary climate-relevant indices for financial institutions.

7Results from my analysis of the emissions index (EE_i) show that the banks, with the exception of an outlier, have fairly similar exposure to climate risk through their loan portfolios, given the GHG emissions represented by their sectoral lending. On the funding index (EF_i), banks have differentiated funding of climate risk through their lending that is fairly proportional to their market shares of gross loans. Thus, larger (smaller) banks engage in higher (lower) funding of climate-related risk. These two complementary indices provide a first set of quantitative climate-related financial disclosures that are comparable across Kenyan banks.

8Further, I enhance the analysis using two forward-looking scenarios: one being the 2030 business-as-usual (BAU) emissions forecasts and the other being a 2030 transition scenario of reducing GHG emissions by 30% relative to 2030 BAU as per the country’s Nationally Determined Contribution (NDC) target. From the forward-looking analysis, banks with a high lending concentration in the manufacturing, energy, and water sectors are expected to have an increase in their risk exposure given the expected large increase in emissions in the energy sector under both the 2030 BAU scenario and the 2030 transition scenario. Overall, larger (smaller) banks will still have higher (lower) funding of climate-related risk.

9The fairly similar climate risk profiles of Kenyan banks means that banks face similar exposure to climate-induced risk factors given the GHG emissions represented by their sectoral loan composition. From the funding index, the key implication is that any climate financial policies adopted by the CBK or the government that aim at low-carbon transition in the banking industry by reducing lending to high emission sectors should not target any specific banks but rather be formulated taking into consideration the proportionality of climate risk funding to the market shares of gross loans. This, in fact, would create an incentive for the CBK or government to propose market-led initiatives by banks to divert lending away from high-emissions sectors, since the banks can contribute to the transition cost in proportion to their market shares of gross loans without any particular banks being unfairly targeted or singled out.

1.1 Climate risk management framework in Kenya

10According to the Government of Kenya (2016), Kenya is highly prone to natural disasters within the Horn of Africa with the most common hazards being drought and flooding. The impact of these hazards, already affecting millions each year, is expected to be amplified by climate change, which exacerbates the intensity and frequency of these physical risks that affect key economic sectors like agriculture.

11Kenya’s climate risk management framework is designed in alignment with the Paris Agreement that aims at holding the increase in global average temperature to well below 2^C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5^C above pre-industrial levels, recognising that this would significantly reduce the risks and impacts of climate change (UNFCCC, 2016). However, the country still faces some key challenges in climate and disaster risk management. Firstly, climate mitigation and adaptation strategies are spread across multiple government ministries, departments, and agencies. Secondly, the climate action mandate is spread across the two levels of government, national government and devolved counties. Thirdly, climate efforts are mostly concentrated within the environmental sector and there is need for more active collaboration with stakeholders in other key sectors of the economy, such as the financial and transport sectors.

12The latest national GHG emissions are reported in the NDC Sector Analysis Report (Government of Kenya, 2017). This is per the country’s submission of Intended Nationally Determined Contributions (INDCs) to the United Nations Framework Convention on Climate Change (UNFCCC). The NDC sector analysis identifies six sectors across which emissions are reported: energy, transport, industry, waste, forestry, and agriculture. The country’s mitigation target is to abate overall GHG emissions by 30% by 2030 relative to the business-as-usual (BAU) scenario. This followed a study on the technical potential of emission abatement across all sectors.

13The NDC goal to abate GHG emissions by 30% relative to 2030 BAU does not mean a 30% reduction of emissions equally across all six sectors given the different abatement potentials across sectors. For example, agriculture accounts for the highest contribution (40%) of national GHG emissions; however, the sector’s abatement target is 4% reduction in 2030 BAU emissions. This is mostly explained by the challenge of changing practices in the agricultural sector and further complicated by the challenge of acquiring necessary data to calculate the potential and impact of mitigation options in agriculture, relative to other sectors such as energy and transport.