Relevance: GS-3: Indian Economy, environmental pollution and degradation, environmental impact assessment.

Key Phrases: RBI, Climate risk, Financial system, Sustainable Finance Group, Survey on Climate Risk and Sustainable Finance, Physical Risks, Transition Risks, Climate-related policies, Emergence of newer technologies, Financial Stability Board’s, Network for Greening the Financial System

Context

• The Reserve Bank issued a consultation paper on climate change and related risks in order to equip banks and financial institutions to effectively deal with the issues arising out of climate change.

Background:

• As the regulator of banks, the Reserve Bank of India has a significant role to play in shaping how banks adapt to climate change.
• In recent years, the RBI has moved to acknowledge the risks climate change will pose to financial stability.
• In May 2021, it set up a Sustainable Finance Group within its Department of Regulation “to coordinate with other national and international agencies on issues relating to climate change”.
• The Reserve Bank also released on its website the results of a Survey on Climate Risk and Sustainable Finance undertaken in January 2022.
  • The survey was carried out to assess the approach, level of preparedness and progress made by leading scheduled commercial banks in managing climate risk.
  • The survey covered 12 public sector banks, 16 private sector banks and 6 foreign banks in India.
  • It provides useful insights, and the feedback from this exercise will help in shaping the regulatory and supervisory approach of the RBI to climate risk and sustainable finance.
• In a bulletin issued in March 2022, the RBI analysed the impact of the green energy transition on fossil fuel dependent industries.
• Recently, Reserve Bank of India has released a Discussion Paper on Climate Risk and Sustainable Finance.

Highlights of Discussion Paper on Climate Risk and Sustainable Finance of RBI:

• The paper highlights gaps in the way climate change as a material risk is treated by India’s banks.
• Several private and public sector banks still have not considered climate change as a material threat.
• It notes that major private banks have not discussed the risks and opportunities related to climate change and sustainability. This can be bad news for the government’s ambition to decarbonize the economy.

Climate-related risk on financial sector:

Climate change can impact the financial sector through two broad channels i.e., physical risks and transition risks.

• Physical Risks
  • It refers to the economic costs and financial losses resulting from the increasing frequency and severity of extreme climate change-related weather events such as acute physical risks and chronic physical risks.
  • Physical risk impact depends on geographical locations, as different regions display varied climate patterns. For example,
    • Expected cash flows to the REs (Regulated Entities) from exposure may be stressed on the occurrence of a local/regional weather event.
    • Chronic flooding or landslides may present a risk to the value of the collateral that REs have taken as security against loans.
    • Severe weather events may damage a RE’s owned or leased physical property and data centers, thereby, affecting its ability to provide financial services to its customers.
• Transition Risks
  • It refers to the risks arising from the process of adjustment towards a low-carbon economy.
  • The process of transition i.e., reducing carbon emissions may have a significant impact on the economy. Like
    • Changes in climate-related policies and regulations
      • Climate related mitigation policies could include reduction in financial valuation or downgrade in credit ratings of businesses adversely affecting the climate or introduction of subsidies to encourage the use of energy efficient goods/processes.
    • Emergence of newer technologies
      • Technological innovations such as production, storage, and transport of cleaner energy may decrease the value of assets dependent on the older technologies, i.e., the stranded assets, causing mark-to-market losses on investment portfolios or reduction in cash flow of certain borrowers.
    • Shifting sentiments and behaviour of customers.
      • Shifts in public sentiment including that of consumers and investors can affect the economy and financial system.

Shortcomings in the consultation paper

• One notable absence in the consultation paper is the central banks’ future plans on climate change and sustainability in the context of the central bank’s role in financial stability and supervisory practices.
• The paper cited the Financial Stability Board’s focus on regulatory and supervisory approaches wherein the Network for Greening the Financial System (NGFS) paper clearly mentions that climate-related risks fall within the banking supervisory and financial stability mandates of central banks and financial supervisors.
• It would have been helpful if the RBI had come up with macro-prudential supervision practices concerning climate change.
• Another big miss is a discussion and framework for the consideration of climate and sustainability risk in monetary policy.

Some recommendations:

These include many areas including governance, strategy, risk management, reporting and disclosure as well as capacity building. For example,

• Task Force on Climate-Related Financial Disclosures:
  • To overcome climate-related risk, an important aspect is Climate-Related Financial Disclosure, which is a good starting point for all stakeholders including investors and regulators. To bridge the asymmetric information barriers between banks and investors, the paper gives a strong push to follow Task Force on Climate-Related Financial Disclosures (TCFD), an international standard for climate-related risk disclosure.
• Capacity building and training:
  • The emphasis on capacity building and training on climate change across the board including senior management can go beyond bridging the skill gap and potentially foster a culture of integrating climate change in all decision making.
• Forward-looking tools:
  • Another practical recommendation is to adopt forward-looking tools such as stress testing and climate scenario analysis to assess the true risks of climate change. Existing tools are largely based on historical data, and do not capture the true climate change risks.

Way Forward:

• We need to be conscious that addressing climate risk in the financial sector is our joint responsibility as it may affect the resilience of financial system in long run. As the risks and opportunities and financial impact arising from climate change vary across jurisdictions, this poses unique considerations for emerging economy like India.
• The challenge before us is to mainstream green finance and think of ways to incorporate the environmental impact into commercial lending decisions while simultaneously balancing the needs of credit expansion, economic growth and social development.
• Recently, RBI have set up a Sustainable Finance Group (SFG) within the Department of Regulation in the Reserve Bank which will be spearheading RBI’s efforts and regulatory initiatives in the areas of sustainable finance and climate risk.

Source: The Hindu BL

Mains Question:

Q. What types of risks financial sector of India is facing due to climate change? Suggest measures to overcome these risks? (150 words).