Like the Covid-19 pandemic, the impacts of climate change transcend both geographical and sectoral boundaries. The 2021 Climate Risks Index published by Germanwatch ranks India among the top 10 most vulnerable countries.
Climate change poses significant tail risks with catastrophic system-wide consequences to the stability of entire financial systems. These risks — termed ‘green swan risks’ — can manifest themselves through two channels. First, physical risks arising from the impact of an increased frequency of extreme-weather events cause losses and damages to infrastructure and worsens credit, liquidity and operational risks borne by firms, which in turn also sends insurance claims soaring.
Second, transition risks are posed during transition towards a low-carbon economy, where the current economic architecture is not able to fully incorporate climatic risks in asset prices. In the eventuality of a messy and disorderly transition, there is a risk of trillions of the currently highly valued brown assets becoming stranded, thereby endangering overall financial stability.
In recognition of these macro-financial risks, central banks have emerged as important players in the prevention and mitigation of climate change-related impacts on the economy and financial system. The Network for Greening the Financial System (NGFS), an international coalition of central bankers formed in 2017 has emerged as a frontrunner in developing and propagating research on climate-related risks to firms and the financial system and currently has over 95 member countries.
Member countries of the NGFS have adopted various ways to mitigate the impact of climate change, including the creation of a green taxonomy to differentiate between green and brown assets and encouraging climate-related disclosures by private firms.
Central banks’ other more proactive steps are with regard to greening of their portfolios as well as the greening of macroprudential policy and possibly even monetary policy. Among all these potential roles, the latter (i.e. greening of monetary policy) is the most controversial, though it has its share of proponents, the most vocal of which is the European Central Bank (ECB). The ECB released an action plan on July 8, 2021, outlining its commitment to include climate change effects in setting the future course of monetary policy.
Enter the RBI
Critics have argued that the RBI has been relatively slow in its progress. Evidence offered in this regard is the RBI’s lack of presence and membership in global standard-setting bodies in the evaluation and impact of climate risks, as well as a low degree of articulation by its key central bankers of incorporating climate change effects into its policy-setting.
The RBI seems to have taken heed of this in recent times. It became a member of the NGFS in April 2021. In its recently released Financial Stability Report (FSR) 2021, it identified climate change as a major risk to financial stability and also acknowledged the significance of a more comprehensive objective of identification, assessment and mitigation of climate risks on financial stability. As a precursor to this, climatic risks also found mention in the RBI’s Annual 2020-21 Report, where it emphasised incorporating climatic risks into the risk and compliance strategies of commercial banks as one of its future goals.
Nevertheless, there is scope for the RBI and financial regulators in India to do even more, the foremost of which involves mandatory disclosures of climate risks by all firms, especially the systemically important financial institutions, and promote research focused on development of more forward-looking risk metrics to quantify the scope and scale of climate-related financial risks.
This should be complemented by a system-wide climate-related stress tests and scenario analysis to gauge the resilience of firms and industries to climate change effects, as well as the consideration of certain macroprudential policies like green countercyclical capital buffers. The RBI can also start by greening its own portfolio, following the footsteps of its Singapore counterpart.
Although climate policy is foremost the remit of elected policymakers who can set a price on carbon emissions and can plan national economic and development policies to align with a sustainability agenda, its devastating (and imminent) consequences across countries and sectors make concerted action by multiple authorities on various fronts an imperative. As the private sector is one of the key stakeholders in enabling the provision of green finance, their participation and receptivity towards the climate change agenda is key.
Two of India’s biggest private sector players – the Reliance Group and Adani group – have both announced massive sums of investments into renewable energy as part of a strategic recalibration (i.e. greening) of their portfolios. More than 30 industry participants from India are also members of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) which is an industry-led body working towards the creation of a harmonised set of rules for private sector firms to disclose climate risks. Both these developments point towards the private sector as playing a positive role and being potential collaborators in mitigating climate-related financial risks.
Keeping up this momentum in the finance sphere would require a more proactive role to be played by the RBI in both facilitating green finance and mitigating the impact of climate-related financial risks. A start has been made; much more needs to be done.
Rajan is Yong Pung How Professor and Gupta is PhD student, Lee Kuan Yew School of Public Policy, National University of Singapore