Greening the state finances

The Reserve Bank of India (RBI), in its recent report on state finances, has suggested that states should increase their capital expenditure in green energy, preferably using climate-incentivised borrowings like green bonds which are debt securities issued specifically to finance projects that contribute positively towards the environment.

RBI’s Deputy Governor, in a recent IMF discussion, observed that in the financial markets, there is a trend towards ESG-focussed funds that are transparent and provide climate-related disclosures from companies. Also, the issuance of Sovereign Green Bonds (SrGBs) helps in price discovery of other financial instruments, and leads to the development of a market for green financing.

India’s Nationally Determined Contributions (NDCs) require that non-fossil energy capacity reach 500 GW by 2030, and renewable energy such as solar, wind etc. should fulfil 50 per cent of the country’s energy needs. A report by the Ministry of Finance estimates that this renewable transition needs Rs 158 lakh crore for the electricity sector and another Rs 213 lakh crore for the fossil fuel sectoral changes.

Increasing the capital expenditure on energy infrastructure can fulfil the NDCs, and it is time for India’s states to pitch in and shoulder the responsibility of this renewable transition, contributing their fair share in India’s green transition. The greening of our state expenditures is a logical next step for our sustainable future. More so, because the share of states in Gross Fixed Capital Formation (GFCF) has always been more than the Central government. Their combined share in GFCF stood between 10 to 12 per cent, of which 60 per cent has always been coming from the states.

An analysis of data on state finances reveals that state capital expenditure is already on the rise. In the last five years, the state capital outlay has increased by almost Rs 3.6 lakh crore, and its share in GDP has risen from 2.3 to 2.9 per cent between 2017 and 2023, compared to a 30-year average of 1.9 per cent.

The expenditure on development has also grown in the last five years, reaching to Rs 32.35 lakh crore in 2022-23. While the expenditure is rising, states have managed to reign in on their fiscal deficits. Gross Fiscal Deficit (GFD) of states as a percentage of GDP has increased marginally from 2.5 per cent in 2018-19 to 3.4 per cent in 2022-23, which is well within the 4 per cent indicative target set by the Centre.

Recent years have seen a gradual movement of states towards the financial markets, and away from bank lending. Between 2017 and 2022, the share of market loans as a percentage of total liabilities rose from 48.8 per cent to 62.4 per cent, along with a simultaneous decline in bank loans for states by 0.9 per cent. Currently, this increase in market borrowing is being used to fund fiscal deficits and not for capital creation. The share of market borrowings used to fund the Gross Fiscal Deficit (GFD) has grown over time, and between 2014-15 and 2018-19, it rose from 63.10 per cent to 80.63 per cent. Compared to the Centre, state governments are borrowing more from the market. In 2018-19, for the first time in 30 years, the state share of market borrowings as a percentage of GFD surpassed that of the Central government by almost 20 per cent.

The weighted average yield on State Government Securities (SGS), formerly known as State Development Loans (SDL), has been falling over the last decade, and stood at 6.98 per cent in 2021-22. The yield spread between SGS and Government of India securities has also fallen from 65 basis points in 2018-19 to 31 basis points in 2022-23, which implies that the premium charged by the financial markets for SGSs has reduced, suggesting an increased investor interest in them.

The states of Uttar Pradesh, Maharashtra, Karnataka, Madhya Pradesh and Tamil Nadu account for 40 per cent of capital outlay undertaken by states, and it would be very easy for them to lead the green transition. The share of SGSs in their outstanding liabilities has been growing, while their loans from the Centre have seen a decline between 2020 and 2023.

The 15th Federal Finance Commission of India had also recognised the need for integrating environmental objectives in state public finances. In the report of the 15th Finance Commission (2021-2026), Forest & Ecology was included as a criterion in the horizontal devolution of funds, moving away from the previously used term ‘Forest Cover’. The weightage was also increased from 7.5 per cent to 10 per cent, signalling the growing relevance of environmental criteria in financial decision making.

The lower yields on SGSs, along with the growing exposure to financial markets and a controlled fiscal deficit, gives states a chance to begin the greening of their rising capital expenditures, and green bonds can do this effectively. The Government of India issued its first batch of sovereign green bonds at the start of 2023, and the market response was quite overwhelming; not only were they oversubscribed four times, they were also purchased at a premium i.e., the yield on green bonds was 5 and 6 basis points below India’s 5- and 10-year government securities, respectively.

To improve access to climate finance using green bonds, states must develop governance mechanisms that will create transparency in the management and use of green bond proceeds. Generally, green investors consider reputation to be a significant factor in judging the veracity of an issuer’s green claims. This is because of an abundance of proposals which claim to be green and are anything but green. This phenomenon of ‘greenwashing’ has forced many investors to stay away from green financial instruments. In the international markets, this problem has been mitigated to a large extent, with issuers now assisting their proposals with second-party opinions. These are issued by independent organisations such as Sustainalytics and Centre for International Climate and Environmental Research (CICERO) who certify the authenticity of the bond proposals to the investors.

The Ministry of Finance, Government of India, also issued its ‘Framework for Sovereign Green Bonds’, which sets forth the obligations of the Government of India as a green bonds’ issuer. This framework outlines transparent procedures for fund management, and lays down the core principles for green project categories and the decision-making processes. State governments can take a cue from this framework, and modify it in accordance with their capital requirements and environmental priorities. This will create transparency in their green bond issuances, and also attract investors.

Financial innovations like green bonds are a boon for governments transitioning to sustainability. With the rising development expenditures, falling yields, and the emergence of green bonds, there is an opportunity to re-orient India’s state finances, and sub-sovereign green bonds could be the means to do it, assisting India in its evolution as a greener and more sustainable economy.

Praveen Garg is a retired IAS officer, former Special Secretary & Financial Adviser to the MoEFCC, and President, Mobius Foundation. Pawan Jai Singh Rathore is Research Associate, Mobius Foundation. Views expressed are personal