The story so far: Seeking to institute a framework for regulated entities to tackle climate-related financial risks, the Reserve Bank of India (RBI) on February 28 presented draft guidelines on Disclosure framework on Climate-related Financial Risks, 2024. The Statement on Developmental and Regulatory Policies, presented along with the Monetary Policy statement on February 8, 2023, had recognised that climate change can translate into financial risks for regulated entities. It further held that this could have broader financial stability implications. Comments and feedback on the draft framework are invited until April 30.
How is climate change going to bother financial institutions?
According to the regulator, climate-related financial risks may emanate either directly from climate change events or as an outcome of efforts to mitigate climate change. In the build-up to the latest draft guidelines, the RBI had released a discussion paper on Climate Risk and Sustainable Finance in July 2022. Broadly, the paper categorised potential effects into physical risks and transitional risks.
Physical risks refer to economic costs and financial losses as a consequence of the increasing frequency and severity of extreme weather events (like heatwaves, landslides, storms and wildfires), long-term gradual shifts in climate (such as extreme weather variability, rising sea levels and ocean acidification, among others) and indirect effects (like degradation of soil quality or marine ecology, among others). The impact may vary subject to geographical locations. Although, any exposure to such risks may stress an entity’s cash flows, the primary risk emerges out of a potential disruption of a corporate value chain or lower economic or sectoral activity. Further, events such as chronic flooding or landslides may risk the value of a collateral (especially immovable property) taken as security against loans. Severe weather events could also damage banking entity’s properties or data centre assets, impacting their ability to provide services to customers.
The other set relates to transitional risks, meaning associated risks caused by a transition to a low-carbon economy. This could manifest in a potential downgrade in credit ratings or financial valuation because of a climate mitigation policy or introduction of incentives encouraging the use of energy efficient means. It may entail increased costs or an overhaul of operations. Technological innovations (towards clean energy) could depreciate the value of (existing) assets dependent on older technologies, leading to a reduction in the cash flow of certain borrowers.
Shifts in public sentiment also have a role to play. This refers to an increased preference for savings, projects and/or investment instruments with more climate-friendly policies and fostering a positive impact on the environment.
How is this playing out in practice?
Banks may face credit risk should their customers’ value of assets depreciate, or if their supply chains are impacted affecting operations, profitability and viability. This would impact the borrower’s capacity to service or repay debt, with the lender unable to fully recover losses.
At the same time, climate change can spur a demand for liquidity. This can be in response to extreme weather events or consumers perceiving future difficulties in liquidating their assets if a climate event has a negative impact. This may in turn impact an entity’s capacity to raise funds and address obligations. Banks also stand the risk of not meeting their exposure to claims (say, against insurance products) from customers who are seeking to recover their climate-related losses. This could be particularly acute if there is a heavy concentration of a vulnerable sector in their portfolio.
Lastly, markets risks may emerge should there be a shift in investor preferences or climate induced adverse effects on underlying economic activity.
Non-Banking Finance Corporations (NBFCs) are particularly vulnerable, as argued in the Report on Currency and Finance (May 2023). NBFCs extend about half their gross credit to the power and automobile sectors – both of which have high carbon footprints. Six per cent of the overall money is extended to MSMEs which typically depend on conventional fuel to operate. Thus, considering their forward and backward linkages, it cautioned about “large-scale default” translating into “macro financial instability” in these sectors.
How does the framework propose to address this?
Disclosures would serve as an updated source of information for various stakeholders (customers, depositors, investors and regulators) to understand the climate risks an entity is facing, along with the approach adopted to address such issues. It would facilitate an early assessment of risks and opportunities to ensure market discipline.
RBI has acknowledged the uncertainties surrounding the timing and severity of climate-related risks. These threaten the “safety, soundness and resilience” of individual entities, and in turn, the stability of the overall financial system. Conventional backward-looking risk assessment methods are unlikely to adequately capture future impacts. RBI has observed that future impact would be determined by actions taken today, especially when greenhouse gas emissions above a certain threshold have irreversible consequences.
For financial institutions, adequate information on this front would help avert the possibility of mispricing assets and misallocation of capital by banks. The draft framework proposes disclosures be made on four parameters: governance, strategy, risk management and metrices and targets.
Disclosures related to strategy and risk management
Strategy-based disclosures must detail identified climate-related risks and opportunities over the short, medium and long term. Disclosures must also cover the impact on their businesses, strategy and financial planning, along with its strategy and business model to adapt/mitigate potential risks emanating in the short, medium and long term.
The basis of risk management is to communicate processes and policies to “identify, assess, prioritise and monitor” climate related risks, processes to manage them and the extent to which they are integrated into an entity’s internal control framework. In other words, they must disclose how the nature, likelihood and magnitude of the effects of climate-related financial risks are ascertained.
Disclosures related to metrices and targets?
Disclosures on metrices and targets are to communicate the entity’s performance in relation to its climate-related financial risks and opportunities. These may also be used to indicate progress towards any climate-related targets it may have set, or those it is required to meet as per a statute or regulation. These would be based on greenhouse gas emissions categorised into Scope 1 (emissions from sources owned or controlled by them), Scope 2 (indirect greenhouse emissions from purchased or acquired electricity, steam, heating or cooling brought in for the entity) and Scope 3 (occurring in the value chain, including both upstream and downstream emissions.