Climate Change Opportunities and Threats in Microfinance (Part 2 of 2)
In a previous post, I explained why climate change was important for both low-income populations and the microfinance institutions (MFIs) that serve them. As a result, I suggested internal organizational changes that the MFI could take to try to palliate the effects of climate change disasters. I also highlighted the increasing relevance of energy related microfinance loans.
In this post I will suggest that MFIs can also modify the covenants and conditions in their existing financial products, in order to encourage their borrowers to palliate the negative effects of climate change.
Broadly speaking, MFIs offer three types of products: loans, savings and insurance, all of which can be reconfigured to deal with global warming. Each product can be modified depending on the type of shock MFI customers might suffer. For instance, in areas which are becoming more prone to flooding, MFIs can encourage aquaculture initiatives among farmers, floating gardens, investments on raise tube wells for safe water and new houses to be built on raised beds or raised embankments. All these measures can be supported by making use of loans, savings and insurance products that include a set of climate sensitive conditions.
Unfortunately, the microfinance community has barely started scratching the surface of how to modify existing products to adapt to climate change. Instead, MFIs have tended to fall back upon a reactive approach in which the current year’s disaster is dealt with as it unfolds, rather than taking a more proactive attitude to managing weather changes. As a result, field officers working for MFIs are finding themselves increasingly at a loss when having to adapt to the changing needs and demands of current or prospective customers that want to circumvent the effects of expected climate changes.
Most pioneering MFIs in this field are based in Bangladesh (Agarwala and Carraro, 2010), which have a track record for innovativeness and have been forced to deal with some of the manifold consequences of climate change, namely, floods and droughts. Grameen, BRAC, ASA and Proshika (the four leading MFIs in Bangladesh) have taken a leading role in the modification and implementation of adapted microfinance products for climate change purposes.
All three types of financial services may be used simultaneously in encouraging adaptation among MFI customers. These modified financial services should also be complemented with training and information initiatives related with how to be prepared for disasters, how to cultivate new cropping partners making use of, for instance joint rice and fish cultivation, or how to protect yields and incomes under variable weather and climatic conditions. Nonetheless, it is likely that loans hold the greatest potential in spearheading this change, because of their overwhelmingly higher penetration in low-income markets as compared with savings and insurance products and their higher degree of flexibility in modifying their contractual terms.
Modification of loan products
Ideally, microcredits should stimulate adaptation to climate change among low-income customers by providing them with a means of accumulating and manage assets, thus reducing their overall economic vulnerability, as well as reducing their vulnerability to climate change risks.
There are two non-exclusive and usually complementary venues to modifying loan products. Firstly, MFIs usually demand from their borrowers loan repayment schedules that entail fixed installments during the duration of the loan. Although this arrangement has an underlying sound economic rationale (see, for example, Karlan and Mullainathan, 2007), it might make it very difficult for borrowers to repay loans when a natural disaster takes place. Therefore, MFIs should consider introducing certain caveats or incentives in their loan contracts to allow for greater flexibility in the repayment schedule should certain events occur.
In this line, most Bangladeshi MFIs now allow their members to reschedule their installments, lower the installment amount and/or extend the repayment period during floods (Dowla and Barua, 2006). Such changes have been shown to significantly ease the burden on borrowers without increasing client default rates (Field and Pande, 2008). It should be noted that this adaptation option can be applied to any region regardless of the type of climate change risks it is expected to suffer.
Secondly, MFIs can change some terms in the loan contract depending on the end-use of the loan and on the climate change risks that MFI customers are expected to face. Customers facing drought or rising sea levels will require different terms in their loan contracts depending on whether the loan will be devoted to water management, agriculture and fishery, forestry, health, or housing.
For instance, take a housing loan. For those regions that are expected to suffer floods, cyclones and tidal surges, MFIs can introduce terms on the loan contract that would force the borrower to build the house above flood levels by making use of stilts, raised beds, or raised embankments. In the case of water management loans in flood-prone areas, MFIs can provide loans on the condition that tube wells are constructed at raised levels to protect against contamination. In the case of agriculture loans in areas with higher changes of drought, the terms of the contract should encourage moving away from water-intensive crops, such as rice, to less needy crops, such as maize, groundnut or sunflower. These options have barely been explored in the MFI community.
Some initiatives to counter the effects of climate change are likely to be applicable to a wide range of areas that may suffer different types of climatic shocks. These “wildcard initiatives” often protect the natural capital on which the borrowers depend and ultimately help build their adaptive capacity. For example, tree planting can help fix the soil to the ground while increasing its humidity and countering the effects of more extreme weather.
All in all, these initiatives, if adequately embedded within loan products, could have extraordinarily positive social impacts and generate significant profits for the MFIs involved, but have not been systematically analyzed by the development community.
Modification of saving products
There are two main reasons why MFIs are interested in encouraging their customers to open saving accounts. From the economic standpoint, savings provide MFIs with a guaranteed fund for their operations as well as being useful as a screening device for lending and insurance purposes. From the social point of view, saving accounts help develop a culture of thrift and prudence among a population who is used to living one day at a time. As a result and when the law permits, MFIs often set up compulsory saving schemes for their borrowers.
Unfortunately, the funds which have been contributed to these saving schemes often become unavailable to the poor during a systemic crisis such as an environmental shock. Instead, MFI customers have to resort to selling fixed assets to generate the cash they need to cope with an emergency. In the presence of more frequent natural disasters, MFIs should allow at least some degree of flexibility into their saving plans as well by introducing voluntary saving accounts alongside or substituting compulsory saving plans.
MFIs are understandably reticent to pass this measure, because such disasters affect a whole region and hence they might give rise to liquidity crises possibly even leading to bank runs. To counter this possibility MFIs would have to set aside larger reserves of their capital thus limiting their growth prospects and profitability. On the other hand, voluntary saving plans would also increase the flexibility and effectiveness of personal savings as a safety net, which in turn would help keep loan default rates low. The positive and negative features of voluntary saving schemes under climate change remain unresolved. Again, Bangladeshi MFIs are pioneering this path by choosing to cede greater control to borrowers over the management of their savings (Agrawala and Carraro, 2010).
Modification of insurance products
Being poor is not only about surviving with a tight budget, but also about having to deal with an unpredictable and irregular income. This state of affairs is made worse when low income households suffer external shocks like weather disasters or health emergencies. Their inability to mitigate these low-frequency but high intensity risks often forces them to sell their assets, take on high-interest loans, and exhaust their savings.
The increase in variability and unpredictability of weather patterns will negatively affect agriculture, livestock, housing, health and local infrastructures, among others. Such impact will be magnified particularly due to the higher incidence and severity of natural disasters (IPCC, 2007). An additional complexity of climate change phenomena with regards to insurance products is that they will impact all people in the same area. Since the risk is correlated across individuals, community level informal schemes, such as risk-pooling agreements (for example, funeral and burial societies), income support (for example, credit arrangements), and consumption smoothing arrangements (for example, grain banks) will be especially prone to break down (Bhattamishra and Barrett, 2008).
Traditionally, MFIs insurance schemes have been able to deal with risks correlated across individuals (or covariate risks) by pooling the risks of individuals of a similar risk class and transferring it to a larger and more diverse group of insured participants. Unfortunately, climate change will create covariate risk on a scale never seen before. MFIs will need help from outside sources to deal with this immense challenge, since only the biggest MFIs might find it possible to cover areas subject to different climate risks. Most MFIs will have to resort to reinsurance companies to handle such wide covering covariate risk. An alternative possibility would be for governments and donor agencies to build a consortium with many MFIs to pool such risks.
The two most solicited insurance products in the face of climate change are index-based insurance and health and life-related insurance (which were explained in a previous post). Index-based insurance (sometimes also called Index-Based Risk Transfer Products or IBRTPs) is often used to insure agriculture or livestock-related outcomes, such as crop yields, average crop revenues or livestock mortality. The payment structure of the insurance product is determined by an index which is highly correlated with what is being insured. The use of an index decreases the administrative and transaction costs for identifying losses and it limits the influence of the insured in affecting the outcome, since the index is independent of individual actions (IFPRI, 2009). Possible indexes that have been developed already and could be useful in a changing climate are cumulative rainfall, cumulative temperature, flood levels, sustained wind speeds and Richter-scale measures.
Currently, index-based insurance is popular among many MFIs serving farmers with high weather risk and high risk of crop failure due to unpredictable rainfall. Nevertheless, although index insurance is not new, especially in agriculture, it still has potential for improvement, especially on the basis of the increased demands placed on it due to global warming. For example, some MFIs already require their insured customers to engage in more sustainable farming practices by providing insurance only to those crops that are less susceptible to rainfall conditions. A similar approach could be possibly adopted in livestock insurance to encourage the prevention of fatal diseases such as Bovine Tuberculosis and Rift Valley fever that disproportionally besets many areas affected by climate change (WCS, 2008).
Health insurance is the most demanded and sought-after type of insurance (Roth et al. 2006), since health-related shocks are arguably the most dangerous for low-income individuals due to incurred medical expenses and permanent income loss, especially if the health problem affects the main household’s breadwinner. In spite of this mostly unmet need, health and life insurance are likely to experience a further surge in demand in the coming years as the poor suffer the negative effects of climate change either directly due to increased mortality and morbidity, arising from environmental emergencies such as floods or tidal waves, and indirectly, from the income losses and malnutrition due to lower crop yields and livestock deaths.
All in all and in spite of a growing demand, the hurdle created by wide geographic covariate risks due to climate change will increase the risk of insolvency in many insurance programs unless premiums and payouts are reduced, and unless the insurance company holds more reserves. This is likely to reverberate in lower organizational growth rates and profitability. In addition to reinsurance, insurance companies might even need external help in case of a sudden and widespread environmental emergency in order to remain solvent (Hochrainer et al. 2008).
MFIs are uniquely positioned to palliate the negative impact of climate change on the poor. Although Bangladeshi MFIs are leading the way in taking a proactive approach to adapt to climate change, much more work is needed. A more systematic analysis of the different effects of climate change on a geographic level is clearly warranted. Once the climate change risks of a particular region have been ascertained, MFIs would then need to decide which initiatives they will support to palliate the negative effects of climate change on their customers. Only once these initiatives have been selected, will MFIs be able to begin in earnest the task of figuring out how to support low-income households in the face of climate change and natural disasters through the selling of financial services.