2019 was a year of civil protest, political tension and economic uncertainty in which we saw the world’s two prime challenges – climate change and inequality – become even more pressing.
Climate change and inequality
Climate change is one of the greatest global challenges we are facing. Last year marked the earth’s second hottest year on record, with the last decade being the hottest in history. Natural disasters like tropical cyclone Idai that hit Southeast Africa in March, killing hundreds of people in Mozambique and Zimbabwe, are a testament to the devastating effects climate change can have on societies. Climate risk is and will become even more prominent in emerging and frontier markets.
Climate change worsens inequality between and within countries. Developing countries are affected most by extreme weather because they are less equipped to deal with the impact. Climate change also affects the livelihoods of the poorest and most vulnerable communities first. The Intergovernmental Panel on Climate Change predicts that risks related to extreme weather will increase as the global mean temperature continues to rise. Inequality is a key driver of social unrest, which in turn can have a detrimental effect on economic growth and prosperity.
Governments, businesses and investors alike recognize these issues and have placed climate high on the agenda. While the 2019 COP25 failed to reach a much-needed agreement on the way forward, most countries are transforming their pledges into national climate action plans. COP25 marked the last summit before nations commit to new plans in 2020 to meet the target set by the Paris Agreement. Climate protests around the world, including a movement among the youth, are voicing increasing societal concern about the future of our planet.
In 2019, FMO signed the Dutch Climate Accord, a major initiative in The Netherlands to achieve the goals of the Paris Agreement. The Dutch financial sector, including investors and financial institutions, will start reporting on their climate impact from 2020. No later than 2020, signatories will announce their action plans, including reduction targets, for domestic and international investments. FMO also joined the global Platform for Carbon Accounting Financials (PCAF) Core Team to work with other financial institutions to develop a global carbon accounting standard.
European legislators also embarked on their own climate initiative: EU Sustainable Finance. In December, an agreement was reached on a framework for sustainable investments (EU Taxonomy). This unified classification system for sustainable economic activities will become the foundation for the EU green bond standard, methodologies for low-carbon indices, and metrics for climate-related disclosure. Banking supervisors are also taking notice and have shared a first set of expectations on how banks should manage their ESG risks in general and climate risks in particular.
Risks & Opportunities | Climate-related risks affect our portfolio
Extreme weather events and failure of climate change mitigation and adaptation are among the top five global risks. This affects our portfolio in the following ways:
Almost 80% of the economic impact of climate change is absorbed by low and low middle income countries;
Agriculture, food production and deforestation are major drivers of climate change;
In addition to physical risks, transitional risks that affect our clients include changes in climate and energy policies, shifts in technology and liability issues due to damaged assets.
Link to our strategy
Higher Impact Portfolio: focus on Reducing Inequalities (SDG 10) and Climate Change (SDG 13) in targeted sectors and regions and raising ESG standards.
By 2050, two-thirds of the global population is expected to live in Asia and Africa. This brings challenges as well as opportunities to these regions. Rapid population growth challenges the poorest of countries with respect to tackling poverty, inequality, hunger and malnutrition. Other countries have experienced a growing working age population and middle class, creating opportunities for accelerated economic growth. A stable middle class provides a solid foundation for economic progress by driving consumption and domestic demand, thereby also improving living standards. The internet and related technologies such as mobile devices have also reached developing countries much faster than previous technological innovations, which drives higher growth in these markets.
The world around us, however, remains uncertain. Trade disputes between the US and China have resulted in significant tariff increases, affecting business sentiment and confidence. Several countries faced economic and humanitarian crises as a result of social unrest and political instability. The situation in the Middle East put pressure on oil and related energy prices. Interest rates are at a historical low, creating opportunities as well as challenges as it may be more difficult for FMO to find good quality assets to invest in. Furthermore, the recent outbreak of the COVID-19 (Coronavirus) is affecting the global economy and productivity. For example, the solar industry supply chain is affected as a result of work stoppage in key manufacturing hubs in China.
Risks & opportunities | Country risks are higher in emerging and frontier markets
Political risks relate to state failure, government and political instability;
On average, Latin America and the Caribbean and Africa display elevated country risks, whereas Asia Pacific and Eastern Europe and Central Asia range between moderate and elevated risk;
Economic instability may harm countries that, for instance, export commodities or have large current account deficits. This may limit the ability of our clients to grow, may reduce the value they create in their countries and may hurt their ability to fulfill their obligations to financiers.
Link to our strategy
Higher Impact Portfolio: maintain strong geographic diversification and closely monitor country risks.
There is increasing liquidity in development finance. This is caused, among others, by the establishment of new institutions such as the DFC and FinDev, more capital being raised by existing institutions and substantial investment flowing from China towards emerging economies. This is a positive development for financing the SDGs. At the same time, when DFIs and blended funds compete for the same projects, this may increase pricing competition and reduce the bankability of investment projects. Ultimately, this could crowd out private investors, which undermines the role of DFIs.
The development finance sector is affected by the competition between China and the United States for influence in Africa, mainly through investments in infrastructure. At the same time, efforts are ongoing to increase cooperation among African countries that will stimulate trade and foreign investment in the region. In 2019, 53 states signed the African Continental Free Trade Area, which, when ratified, will improve business with and between member states. Africa’s rapid development in the past decade, and its continued expected economic and demographic expansion, present new opportunities for (Dutch) companies.
Considering these developments, the European Union (EU) is in the process of reforming its financial architecture towards its own development policy. These reforms are part of a systemic reform of the European Financial Architecture for Development.
Risks & opportunities | Creating a level-playing field to crowd in private investors
The role of a DFI is to be additional to the market and to crowd in private investors so they can invest in markets that are often perceived as too risky;
Below market pricing can crowd out private investors who are crucial in our quest to achieve the SDGs.
Link to our strategy
Deeper relationships: mobilize commercial investors and create opportunities to leverage impact in our markets.
Harmonization of impact measurement
The introduction of the SDGs has given stakeholders a common language and a shared vision of the world, which makes working together easier. Collaboration within the industry is needed to achieve the SDGs, which the UN estimates will require US$2.5 trillion per year in developing countries alone. In 2019, several initiatives were launched to harmonize the measurement and disclosure of development impact. Harmonization facilitates the development of common standards by which DFIs and private impact investors can measure and report on development impact achieved in order to track progress on the SDGs. This is part of the much-needed professionalization of the impact investment industry and a steppingstone for the creation of a non-financial accounting standard that will be applicable to all investors and enterprises.
Risks & Opportunities | Raising ESG and impact standards
Harmonization is important to bring clarity, consistency and alignment between DFIs. This will raise industry standards with respect to ESG and impact and will enable us to work together to achieve the SDGs.
Link to our strategy
Deeper relationships: working with others to achieve the SDGs.
Transparency and accountability
With climate and other impact related topics high on the agenda, our stakeholders expect development banks and their partners to be transparent about and accountable for the full impact of their investments. FMO recognizes this responsibility. Depending on a project’s risks and adverse impacts and the project phase of development, FMO expects its clients and investees to engage with local communities on project risks, impacts and mitigation measures. As stated in our Sustainability Policy and Disclosure Policy, we also engage in an ongoing dialogue with stakeholders such as NGOs. Tapping into their expertise increases our understanding of local contexts, which in turn informs our decision-making and policy development. Furthermore, we disclose ex ante and ex post project information on our website.
Risks & opportunities | Managing ESG and reputational risk
Our stakeholders hold FMO accountable for ESG-related incidents that occur with our clients. They also challenge us to fully embed ESG into our investment process and be transparent about how we have done that.
Link to our strategy
Higher productivity: responding to stakeholder needs and regulatory requirements to improve our processes so that we can deliver high impact.
- 1 Germanwatch (2020). Global Climate Risk Index 2019.
- 2 Intergovernmental Panel on Climate Change (2014). Climate Change 2014. Impacts, Adaptation, and Vulnerability: Summary for Policymakers.
- 3 World Economic Forum (2020).
- 4 United Nations (June 2019). World Population Prospects 2019: Highlights.
- 5 In 2018, the U.S. Senate passed the BUILD Act, creating a new agency – the U.S. International Development Finance Corporation. The DFC combines the Overseas Private Investment Corporation and Development Credit Authority, adds new development finance capabilities including equity mandate and has a higher lending limit.
- 6 In March 2017, Canada’s federal budget confirmed the Government of Canada’s intention to create a development finance institution, capitalized with US$300 million.
- 7 UNCTAD World Investment Forum. Financing for SDGs: Breaking the Bottlenecks of Investment from Policy to Impact. https://worldinvestmentforum.unctad.org/financing-for-the-sdgs/