Relevance: GS-3: Inclusive growth and issues arising from it; Conservation, environmental pollution and degradation, environmental impact assessment

Key Phrases: Climate Risk Management, Climate Change, Types of Risks

Context:

• RBI Governor has recently announced that the central bank will soon issue a consultation paper on climate risks for banks and the financial sector. Thus, the issue of climate risk management in the banking sector is brought into the discussion

Background

• The surface temperature of the earth has risen at a record pace in recent decades, creating risks to life, ecosystems, and economies.
• Warming caused by greenhouse gasses could damage livability and workability—for example, through a higher probability of lethal heat waves.
• Global warming will undermine food systems, physical assets, infrastructure, and natural habitats.

The RBI has earlier decided to join as a member of Network for Greening the Financial System (NGFS) - a coalition that brings together central banks and supervisors working on climate and green finance issues from across the globe. So the recent announcement by the Governor is in line with RBI’s decisions in the past.

Climate Risk

Until very recently it was not a major issue but in the last decade it has started seeking attention from policymakers, regulators, or businesses. The countries are becoming increasingly exposed to climate related catastrophes often causing severe disruption in supply chain or hampering business continuity e.g.

• Wildfires in California, Australia, and Brazil, and
• Extreme weather events like droughts or floods.

The risk is further compounded by mitigation-related regulatory policies that impose high adjustment costs for the businesses e.g. a carbon tax or cap on fossil fuel usage or banning of diesel cars.

Growing Awareness

• According to the 11th Annual EY/IIF bank risk management survey released in 2021, over 91 per cent of the chief risk officers (CRO) and 96 per cent of the board members viewed climate change as the top emerging risk in the next five years.
• Climate risks in the BFSI (Banking Financial Sector and Insurance) can be classified into two major categories:
  • Physical risks: arising from economic costs and financial losses due to physical impacts of climate change and
  • Transition risks: precipitated by significant losses or cost of adjustment because of transition to a low-carbon trajectory.
• Recently, RBI in its report ‘Green Transition Risks to Indian Banks’ has mentioned the transition risk due to the cost of adjustment that falls in the production processes of industries that are directly or indirectly exposed to excessive use of fossil fuel.

Manifestation of these risks

Both the physical and transition risks, arising out of climate related factors may eventually get manifested through traditional risk channels namely:

1. Credit risk either due to reduced borrower’s ability to repay and service debt or bank’s inability to fully recover the loan because of default ;
2. Market risk due to reduction in the financial value of assets, re-pricing of securities and derivatives due to stringent climate regulation;
3. Liquidity risks on account of banks’ reduced access to stable source of funding because of changing market conditions;
4. Operational risk due to legal and compliance risk pertaining to climate-sensitive investment;
5. Reputational risk due to changes in market and consumer sentiment due to changing consciousness on climate.

As traditional risk management approaches are not appropriate for measuring climate risks, regulatory authorities and businesses have opted for stress tests to assess the extent of a firms’ vulnerability to climate change.

Global experience

• The Netherlands, France, Banking Union in Europe, the UK, Australia, Singapore, and Canada are the leaders in this aspect.
• In Asia, the Hong Kong Monetary Authority has also started publishing climate risk guidelines and announcing future climate stress tests.
• People’s Bank of China (PBC) standardized green disclosures and green credit ratings in 2018.
• The Financial Stability Board (FSB) created an industry-led Task Force on Climate-related Financial Disclosures (TCFD) to bring out climate-related information that is financially material.

Indian Scenario

• In May 2021 SEBI mandated top 1,000 listed companies in India by market capitalization to report Business Responsibility and Sustainability Report (BRSR) starting from the financial year 2022-23.
• It is expected to bring in greater transparency and enable market participants to identify and assess sustainability-related risks and opportunities, including climate risks.
• Climate Risk Horizons analyzed 34 largest scheduled commercial banks in India and inferred that only a handful of them have factored in climate risk, albeit only partially, in their business strategies.
• Critical question remains the same - whether the stakeholders such as banks in the BFSI sector are ready to internalize climate risk.

Challenges for banks

• Complexity in climate risk modeling
• Measuring the impact of climate risk while undertaking lending and investment decisions and further integrating that risk in the existing risk and valuation frameworks.
• Dearth of standardized industry models to embed climate risk into enterprise risk management framework.
• Lack of skilled professionals who have a clear understanding of both the worlds — climate risk and finance.
• Most banks confine themselves to a qualitative assessment of climate risks during the loan approval processes. The quantification of climate risk may require quality data that is not always available due to inadequate and at times inconsistent corporate disclosure.

Way Forward

• Thus, banks must act on two fronts: manage their own financial exposures and help finance a green agenda, which will be critical to mitigate the impact of global warming.
• The views and suggestions of all stakeholders are necessary for a more informed and measured approach towards preparing the banking sector to internalize climate risk.
• India must learn from the global best practices and then take a decisive step to tackle climate change and related issues in an effective manner.

Sources:  The Hindu BL

Mains Question:

Q. Banks must learn to factor in climate risk in their policy-making and implementation. Discuss the challenges faced by the banks to tackle climate change and suggest measures for them to improve on their efforts. [250 Words].