CLIMATE CHANGE TECHNICAL NOTE Nepal Finance for Growth DPC (2 of 3) (P176881) Vulnerability Context Nepal is highly vulnerable to the impacts of climate change. According to the Climate Risk Index, Nepal ranks 10th in the world as a country most affected by past climate hazards.[1] The country is also ranked the 44th most vulnerable to future climate risks and 64th least ready country to adapt in the world by the ND-GAIN Country Index.[2] Nepal faces high risks of flooding and landslides, torrential rainfall[3], and an increased risk of glacial lakes bursting. Heatwaves, droughts, and more erratic rainfall are high and rising risks.[4] Nepal also faces threats from slow on-set events apart from these disaster events. Mean annual temperatures throughout Nepal are projected to increase between 0.5°C and 2.0°C by the 2030s. At the same time, projections show a three-fold increase in monsoon rainfall and are likely to contribute to more frequent summer floods. The risk of flooding in the river basins of the non-Himalayan region due to higher monsoon precipitation is projected to increase by as much as 14 to 40 percent by the 2030s. The impact of climate change will be profound across economic sectors. Nepal’s climate vulnerabilities emerge from an interaction of climatic factors with a fragile mountainous topography and ecosystems, monsoon-driven hydrology, unplanned settlements and lack of resilient infrastructure, and an economy that has sustained several shocks in the recent past (floods in 2017, as well as landslides, floods and the ongoing COVID-19 pandemic in 2020). Rising mean annual temperatures are increasingly evident[5] in the high mountains, as permafrost and glaciers have melted, dangerous glacier lakes have formed, and landslides are occurring more frequently. Further, a reduction in winter snow and more significant rainfall variability in Nepal is predicted[6] to adversely impact water security, hydropower potential, food production, and biodiversity. The frequency of droughts is likely to increase, particularly during the winter months and especially in the western Terai plains, with considerable impact on the primarily (75 percent) rain-fed agriculture. With agriculture comprising around 64 percent of employment, most livelihoods are highly exposed to climate change.[7] Climate impacts also affect infrastructure, service provision, and economic productivity. Climate change also poses a risk to the financial sector, not only from physical risk arising from increasing severity and frequency of climate and weather-related events affecting economic assets, but also from transitions risk arising from a transition to a carbon-neutral economy. Prior Actions’ Contributions to Climate Objectives This operation contributes directly to key climate policy priorities in Nepal, including those related to disaster risk financing, reduction and management, low-carbon development, and climate financing. The specific adaptation and mitigation activities under the Program are given in the table below: Table 1: Prior Action-wise Adaptation and Mitigation Actions Prior Action Contribution to climate change adaptation and/or mitigation Prior Action #2. The Nepal Rastra Bank, Before this reform, most financial institutions (FIs) tended to ignore the to strengthen the effectiveness of financial implications of being exposed to environmental risks while making supervision towards a risk-based investment decisions. At the same time, an adequate regulatory framework approach, has: (i) adopted a new Offsite is yet to be created to make climate-informed decisions and incentivize FIs Supervision Manual; (ii) has implemented to offer green finance products. the Supervisory Information System through which banks and financial This reform strengthens the climate resilience of the financial sector by institutions submit their regulatory introducing new climate-related financial risk supervisory practices into the returns; and (iii) endorsed a report by the NRB supervisory framework. The reform provides a coherent and essential [NRB supervision Department/ first step guideline for financial institutions to address and measure climate- Monitoring Unit], building on the related risks using robust metrics and fully incorporate climate dimensions institutional risk profile of all Class A into decision-making. The reform will also enhance Nepal’s progress towards Banks and presenting the findings from the eventual adoption of international standards around climate risk resultant onsite supervision inspections financial disclosure (such as recommendations of the Task Force on Climate- for at least two banks identified as higher related Financial Disclosure (TCFD)) risk. In addition, there is also limited awareness about the green bond market with a shortage of pipeline projects before this reform. The more robust incorporation of climate dimensions in financing decision-making through this reform will pave the way for the GoN to introduce green taxonomy, green loan principles, and incentives for green lending. Prior Action #3. The Executive Disaster risk reduction and management is one of the eight thematic Committee, as authorized under “Disaster priorities under Nepal’s Second NDC.[8] This reform contributes directly to Risk Reduction and Management Act, diversifying financial solutions for the management of climate-related 2074�, has approved the implementation disaster risks in Nepal. Enhanced access to market-based instruments will plan for market-based financial promote proactive use of ex-ante risk transfer to the market. This leads to instruments under the DRF Strategy, improved efficiency in disaster response, safeguards development progress based on a cost-benefit analysis of from climate shocks, and reduces the fiscal impact from ex-post budget financial instruments to reduce the reallocation in the aftermath of climate-related disasters. Government’s contingent liabilities following a disaster. Prior Action #4. The Council of Ministers Nepal’s Second NDC (2020) outlines priority sectors for climate change has approved an amendment to the adaptation and resilience, including industry, transport, and physical “securities registration and issue� infrastructure; rural and urban settlements; forest, biodiversity, and regulation (#2073BS) pertaining to listed watershed conservation; and disaster risk reduction and management. IFC issuers’ disclosure on ESG, focusing on also estimates a total climate-smart investment opportunity (excluding climate change. renewable energy) of US$ 22 billion in Nepal (from 2018 to 2030). However, Nepal faces a critical financing gap for green and climate-resilience investments in these sectors, which need to be closed by mobilizing financing from various sources, including green finance. However, currently, green financing in Nepal is nascent and limited mainly to hydro. While there is a clear need to expand green financing beyond hydro, Nepal faces challenges in mobilizing green and sustainable finance about (1) the need for external capital flows for green investment and (2) the underdeveloped financial system in areas crucial for green investment. This reform will improve the disclosures on their ESG and climate risks and actions to tackle climate change and develop a more climate-resilient economy, taking into account the TCFD recommendations and best international practices and specificities of the local market. Improving market transparency through ESG disclosures is the first step for SEBON before implementing guidelines allowing the need to issue green-labeled securities. It will provide more visibility to investors on the Nepalese companies’ overall strategies to address climate change. Improved ESG and climate risk disclosure practices will also prepare Nepal to attract more international capital looking for sustainable, climate-smart investments. Prior #5. The NIB has revised Directives on The reform enhances the insurance sector’s supervisory infrastructure to Risk-Based Capital and Solvency address climate change risk. The reform, therefore, contributes to a more Framework and Climate-Related Risk stable and climate-resilient insurance system with an ability to help the Disclosures to strengthen its risk-based country better respond to climate shocks. approach to assess and monitor all risks, including climate-related ones. [1] https://germanwatch.org/sites/default/files/Global%20Climate%20Risk%20Index%202021_1.pdf [2] https://gain.nd.edu/our-work/country-index/rankings/ [3] https://thinkhazard.org/en/report/175-nepal; https://climateknowledgeportal.worldbank.org/country/nepal [4] https://thinkhazard.org/en/report/175-nepal; https://climateknowledgeportal.worldbank.org/country/nepal/vulnerability [5] ICIMOD (2019) Hindu Kush Himalaya Assessment Report. [6] Asian Development Bank (2014) Assessing the costs of climate change and adaptation in South Asia. [7] https://data.worldbank.org/indicator/SL.AGR.EMPL.ZS?locations=NP [8] https://www4.unfccc.int/sites/ndcstaging/PublishedDocuments/Nepal%20Second/Second%20Nationally% 20Determined%20Contribution%20(NDC)%20-%202020.pdf