Climate-proofing finances

The greatest risk faced by the world today is ‘Climate Change’, says the Global Risks Report 2024 of the World Economic Forum. The top four risks identified over a 10-year horizon by this report are—extreme weather events, critical change to earth systems, biodiversity loss & ecosystem collapse and natural resource shortages, all consequences of anthropogenic change in climate. However, the negative effects of a changing climate are not limited to the natural world. The former Governor of the Bank of England, Mark Carney, in one of his speeches, observed that as a radical reorientation of capital allocation occurs, the possibility of a systemic financial crisis caused by climate related events cannot be overlooked. According to a 2021 Ernst & Young survey, 91 per cent of the Chief Risk Officers of major banks viewed climate change as the top emerging financial risk over the next five years.

In the 2022-23 Report on Currency & Finance, the Reserve Bank of India (RBI) remarked that financial risks can pose a serious threat to financial stability, causing losses to leveraged financial intermediaries, disruptions in financial markets and frequent repricing of assets. The report highlighted that according to the International Monetary Fund’s INFORM climate risk index, India is most vulnerable to climate-induced physical risks, having a risk index of 5.3, the highest in all BRICS countries and Advanced Economies (AEs), which is quite significant compared to that of China (4.0), United Kingdom (2.0) and Japan (2.4). In terms of preparedness and resilience to transition risk, India is the least resilient (0.80), not only among BRICS countries but also when compared to Advanced Economies (0.50)—with a score of 0 being high resilience and 1 being low resilience.

The Reserve Bank of India (RBI) has identified two broad channels through which climate-related risks can impact the financial sector; these are physical risks and transition risks. Physical risks are defined as the economic costs and financial losses resulting from the increasing frequency and severity of extreme climate change-related weather events like natural disasters, longer term gradual shifts of climate such as sea level rise and the indirect effects of climate change, like the loss of ecosystem services.

Transition risks are those “which arise from the process of adjustment towards a low-carbon economy”, this could lead to a decrease in the value of assets dependent on the older technologies, downgrading of a firm’s credit ratings or reduction in financial valuation of businesses adversely affected by climate change. These risks can also arise from a shift in public sentiment, wherein the customers may request the institutions to redirect their investments towards projects having a positive environmental impact. The speed at which this transition occurs is also a cause of concern. According to the Bank of International Settlements (BIS), “extremely rapid and ambitious measures may be the most desirable from the point of view of climate mitigation, but not necessarily from the perspective of financial stability over a short-term horizon”, since the financial tightening for companies with carbon-intensive activities or an abrupt asset reallocation from brown to green activities can lead to the creation of Stranded Assets. The International Energy Agency (IEA) defines stranded assets as “those investments which have already been made but which, at some time prior to the end of their economic life (as assumed at the investment decision point), are no longer able to earn an economic return as a result of changes in the market and regulatory environment brought about by climate policy”.

The integration of these climate-related financial risks into the bank’s risk management framework is essential to strike a durable balance between risk and reward. The banking sector has started to recognise this emerging threat. The Financial Stability Board (FSB), in its 2021 report, observed that “climate change risks are ascending the hierarchy of threats to financial stability across advanced and emerging economies alike. Consequently, the need for an appropriate framework to identify, assess and manage climate-related risk is imperative”. Hence, the FSB is promoting the adoption of its Task Force on Climate-related Financial Disclosures (TCFD) framework.

The Reserve Bank of India has also taken initiatives towards mitigating the financial risks arising from climate change. It joined the Network for Greening of Financial Services (NGFS) in 2021, a platform for Central Banks to share best practices and contribute towards the development of environment and climate risk management in the financial sector. The RBI put in place a ‘Disclosure framework on Climate-related Financial Risks’ in February 2024, to provide adequate information about climate-related financial risks and to reduce the mispricing of assets. This disclosure framework will be applicable to all Registered Entities (REs), i.e., all Scheduled Commercial Banks, Tier-IV Primary Urban Co-operative Banks, All-India Financial institutions and all top layer Non-Banking Financial Companies. Similar to the thematic areas of FSB’s TCFD framework of 2017, the RBI’s disclosure framework also has four thematic pillars: Governance, Strategy, Risk Management and Metrics & Targets.

The Governance pillar will describe the role played by the Board and the management in assessing and managing climate-related risks. The disclosures under Strategy pillar are to give details about the identification of short, medium- and long-term climate-related risks and their impact on financial planning and business resilience. In order to identify, asses, prioritise, monitor and inform the overall risk management, the third pillar of Risk Management is proposed. The fourth pillar of Metrics & Targets discloses relevant material information such as Scope 1, Scope 2 and Scope 3 GHGs emissions, and describes the targets used to manage climate-related risks and opportunities. These disclosures will be reviewed by the Board of Directors or a Committee of the Board, and will be mandatorily published as part of a RE’s financial statements.

The disclosure framework is in the early stages of adoption, and therefore it’s not possible to judge what its impact would be. However, most experts agree that the integration of these risks into prudential regulation and into monetary policy may not be a sufficient hedge against a systemic financial catastrophe, given the limited number of instruments available to a central bank. The apprehension of insufficient environmental actions by the government, compelling monetary policy to deviate from its objective of price & financial stability looms large. Nevertheless, the willingness of the RBI to adopt global best practices is a testament of its commitment towards the fulfilment of India’s economic aspirations, while navigating the uncharted waters of a low-carbon economy.

Praveen Garg is a retired IAS, Former Special Secretary, Ministry of Environment, Forest & Climate Change, India, and President of Mobius Foundation; Pawan Jai Singh Rathore is Research Associate, Mobius Foundation. Views expressed are personal