Climate change is a systemic risk, acknowledges the much-awaited discussion paper from the Reserve Banks India (RBI) on Climate Risk and Sustainable Finance.
The paper has many interesting findings, and a slew of recommendations but also a lot of areas where it falls short.
The paper highlights gaps in the way climate change as a material risk is treated by India’s banks. A survey by the RBI suggests that several private and public sector banks still have not considered climate change as a material threat. While the risk is considered for Internal Capital Adequacy Assessment Process (ICAAP), it is not integrated with the overall risk management process.
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 decarbonise the economy.
There are also some thoughts laid out on how private banks can deal with climate change risk and scale up green finance. This covers many areas including governance, strategy, risk management, reporting and disclosure as well as capacity building. For example, the recommendation on pricing climate risks through ICAAP and integrating climate change with overall risk management framework will help banks’ resilience against this imminent risk.
Another important aspect is on 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.
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.
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.
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.
This is beginning to attract the attention of the policy and academic community, but is absent in the paper.
Also, to accelerate good practices, the regulator could have used its clout more. For instance, instead of setting a voluntary funding target for green finance, the RBI can make it mandatory for banks to allocate a specific percentage of lending to green finance by adding green business under the priority sector lending (PSL) category.
The RBI can ensure sufficient debt capital flow to green businesses by setting a minimum percentage for them within PSL.
The discussion could have covered areas that go beyond reactive steps to pro-active ones. For instance, banks can include clauses related to climate change in the loan documents such as covenants that would force the borrowers to take the planned actions. The terms of loans can be linked with adherence with the clauses. Banks can also engage with their clients and support them in their sustainability strategy and follow best practices.
While the paper mentions liquidity risk due to climate change, it does not provide ways to address it. One option may be for banks to consider sustainability risk in their liquidity risk management process. The banks’ liquidity ratios can be adjusted by taking sustainability into account, through a differentiated risk-based approach.
Besides the suggestion to upgrade knowledge, the paper can also define the roles and responsibilities of the team members including the senior management involved in sustainability strategy. There can also be a system for reward.
For instance, the compensation structure of top management can be linked with banks’ strategy to climate change — the carbon intensity of lending portfolio and carbon emission from direct operation.
Taking cognisance of the fact that different sectors that banks lend to may face vastly different vulnerabilities to climate risk, there can also be some thought given to sector-specific policies. For example, banks can develop and implement minimum standards for each sector.
Labanya is a climate finance specialist and Meera works on early-stage investments