Policy Circle, October 17, 2022
By Pradeep S. Mehta and Sushil Muhnot
India’s banks, NBFCs face high climate risk: Different studies by climate scientists indicate that a 1.5⁰C rise in average global temperature will cause 3-5 times increase in extreme weather events such as heat waves, droughts, and floods across the world. India is slated to be among the worst sufferers of such events and may suffer huge economic losses. The ministry of earth sciences in its report Assessment of climate change over the Indian region corroborates these findings and further predicts that even if the world meets the Paris Agreement 2015 commitments, global warming may exceed 3⁰C by the end of the century.
The climate challenge would mean additional load on India’s banks and financial institutions. RBI recently came out with a discussion paper on Climate Risk and Sustainable Finance to meet this challenge and understand the risks global warming poses to RBI-regulated entities such as banks and NBFCs. The paper focuses on both physical risks and transition risks.
Physical risks posed by climate change
RBI refers to the rise in the frequency of extreme climate events, long-term shifts in climate, indirect effects of climate change and consequent financial impact on regulated entities. In order to address the consequences of climate change, it has put forward the following suggestions:
Business as usual scenario: The regulated entities can create a business-as-usual scenario and prepare for the climate impact in the next 10-15 years. The Network for Greening the Financial System (a group of central banks) explores a range of climate scenarios for risk assessment. An Indian scenario can be built around the global scenario. Key outputs from this study can be geospatial mapping of areas likely to be affected by events such as:
- outline zones sensitive to rise in sea level,
- areas vulnerable to intermittent drought and flooding, and
- zones that can be affected by landslides, wild fires, and storms.
Each of the geographical areas can be classified into low-, moderate- or high-risk zones in terms of different parameters. It is suggested that a common study can be undertaken on behalf of India’s banks and NBFCs by the Indian Banks’ Association. The standardised risk grading system (low, moderate, high) for different geographical areas, category wise (a, b, or c) can be applied across the board for all institutions.
Baseline survey: Based on the common study, regulated entities can conduct a baseline survey of their existing portfolio in terms of the physical risks involved. Initially, this exercise can be done for projects costing more than Rs 100 crore.
Transition risks towards low-carbon tech
RBI refers to the risks arising from the process of transition towards a low-carbon economy since reduction in carbon emissions can have a significant impact on different sectors of the economy, in terms of:
- Fall in valuations or credit downgrades for businesses such as high emission industries that can be adversely affected by climate change,
- transition to green energy can dampen valuation of plants using fossil fuel such as thermal (coal, crude oil, and gas-based) power generating units,
- shift in public sentiment especially of consumers and investors.
India’s banks and climate risk
Classifying businesses in terms of emission intensity of greenhouse gases and other pollutants under low, medium, and high risk will need guidelines. Apart from greenhouse gases, the other challenges would be water pollution, and solid waste pollution.
Appropriate risk weights can be assigned to each component of physical and transition risks resulting in an easily understandable numerical figure for risks. The risk assessment can be aggregated from the customer level to sectoral level and there on to portfolio level. A system of amalgamation of these risks available in numerical terms can then be evolved to help arrive at a composite risk index.
A granular system of measurement of risk can be introduced to finetune the risk index. It can take into account specifically highly polluting industries and large infrastructure projects costing over Rs 1000 crore for rigorous assessment.
Physical risks will have a higher bearing on the credit risk due to loss in security value, while transition risks will impact more in terms of market risk because of valuation losses. The risk measurement will, however, be limited up to the tenure of loans as per the ALM metrics. Once basic portfolio risk is identified, an analysis of concentration risk, reputation risk, and strategic risk can be undertaken, leading to an HHI index.
As the board of directors of India’s banks and NBFCs are responsible to the shareholders for corporate management, a beginning can be made by reporting to the board:
- Business as usual scenario report taken forward, quantifying the impact on several sectors and businesses to appreciate the need for action, and
- baseline survey reporting along with measurement of involved risks will make the board aware of the climate risks embedded in the current portfolio.
The board can be guided to decide on formulating an acceptable level of risk as part of doing business based on risk appetite. Capital can then be allocated as per the risk, based on the composite risk index.
The board can formulate a forward-looking risk management strategy involving:
- Rebalancing the portfolio composition in the desired direction over a designated period of time,
- creating awareness about climate risk among the staff at all levels through Information dissemination programmes and platforms, and
- capacity building of frontline staff, risk management department and Internal audit staff so as to cover all the three lines of defence.
The Task Force on Climate-related Financial Disclosures (TCFD) set up by the Financial Stability Board published a set of recommendations in 2017 to help businesses disclose risks and opportunities arising from climate change. Forward looking regulated entities will definitely look at opportunities arising from the crisis in terms of availing incentives for renewable energy production, and consumer and investor loyalty by being in the forefront of environmentally sustainable businesses. Financial institutions can be encouraged to go beyond TCFD reporting and take up voluntary targets on green finance, green branches, and green data centres.
(Pradeep S Mehta is Secretary General, CUTS International, a global public policy research and advocacy group. Sushil Muhnot is former CMD, Bank of Maharastra and currently Senior Adviser, CUTS.)
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