By Sushil Muhnot 

The Ministry of Earth Sciences in its report “Assessment of Climate Change over the Indian region” predicts that the global temperature will rise far above 1.5 degrees Celsius leading to rise in extreme weather events like floods and drought causing significant economic losses for India. The Government of India has already committed to achieving Net Zero emissions by the year 2070 as part of its nationally determined contribution (NDC) while setting up ambitious targets to be achieved till 2030 as well.

To meet this challenge our financial system needs to radically reorient its strategy for allocating capital resources and channelising finance. 

The Reserve Bank of India has recently released a Discussion Paper on Climate Risk and Sustainable Finance to meet this challenge and understand the risks – the physical risks and the transition risks – it poses to the financial system with respect to Regulated Entities (RE) such as Banks, NBFCs etc. 

Physical Risks

RBI refers to the rise in extreme climate-related events, long-term gradual shifts in climate, indirect effects of climate change and consequent financial  impact on REs. In order to implement them in the right spirit, it is suggested that:

  1.  Creation of Business as usual scenario: As a prerequisite to implementing these guidelines, REs can prepare a Business as Usual scenario and its impact on the Indian environment for the next 10/15 years to understand the ramifications of the current strategy. The Network for Greening the Financial System (comprising a group of Central Banks ) explores a range of climate scenarios for forward looking climate risk assessment. An Indian scenario can be built around that. Key outputs from this study can be geographical mapping of areas likely to be affected by any of the following: (a) expected rise in sea levels; (b)  intermittent drought and flooding and; (c ) miscellaneous events like landslides, wildfires, storms amongst others. 

Each of the geographical areas can be assigned as Low, Moderate or High risk in terms of that particular parameter. It is suggested that this kind of common study can be undertaken on behalf of all REs by Indian Bank Association (IBA).

The standardised risk grading system (low, moderate, high) for each of the geographical areas, category wise (a, b, or c) can be applied across the board by all REs. 

  1. Baseline survey: Based on the above study REs can conduct a baseline survey of their existing portfolio in terms of the Physical Risks involved. Initially this exercise can be done for high-value projects, such as those costing over Rs 100 crore. 

Transition Risk 

Transition risk, according to 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 the different sectors of the economy. Its impact can be as follows:  

  1. Reduction in valuation or downgrade in credit ratings of businesses adversely affecting the climate, for instance, high emission industries
  2. Transition to green energy can dampen valuation of fossil fuel based plants, such as coal/oil/gas-based electricity generating plants.
  3. Shift in public sentiment especially of consumers and investors can affect businesses.

The Way Forward

Classifying the portfolio of REs in terms of emission intensity of greenhouse gases (GHG) and other pollutants under Low/Medium/High risk is important. This risk qualification or guidelines thereof can be provided by the environment experts for use by the entire RE ecosystem (as part of the earlier mentioned study.) Apart from GHG, other pollutants such as water pollution, solid waste pollution etc.could be considered. 

 Risk Measurement – Creation of a Composite Risk Index 

Appropriate risk weights can be given to the above common standardised grades  – Low / Medium / High risk – for each component of the Physical and Transition risks resulting in an easily understandable numerical figure for the physical and transition risks. This risk assessment can be aggregated from the customer level to sectoral level and there on to portfolio level. A system of amalgamation of both these risks, available in numerical terms, can then be evolved to arrive at a composite risk index. 

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Going forward a granular system of measurement of risks can be introduced to fine tune the risk index. It can take into account specifically high pollutants, constituting GHG and other pollutants, and large infrastructure  projects costing over Rs 1,000 crore for rigorous assessment etc.

Physical Risks will have a higher bearing on the Credit risk due to loss in security value while Transition risks will be more bearing 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 asset liability management (ALM) metrics.

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Once basic portfolio risk is identified, analysis in terms of Concentration risk, Reputation risk, Strategic Risk can be undertaken including preparation of an HHI index to look into concentration risk  etc.

Risk Reporting: As Board  of Directors is responsible to the shareholders for the corporate management, beginning can be made by reporting to the Board: 

  1. Business as usual scenario report taken forward quantifying huge impact on several sectors and  businesses to appreciate the need for action
  2. Baseline Survey reporting along with measurement of involved risks will help the Board become aware of the climate risks embedded in the current portfolio

Risk Appetite: The Board can be guided to decide on formulating an Acceptable level of risk as part of doing business, based on the risk appetite. Capital can then be allocated for this risk based on the Composite Risk Index.

Risk Management Strategy: The Board can formulate a forward looking strategy involving:

  1. Rebalancing the portfolio composition in the desired direction over a designated period of time
  2. Creating awareness about climate risk among the staff at all levels through Information dissemination programmes and platforms
  3. Capacity building of Front line staff, Risk management department and Internal audit staff so as to cover all the three lines of  defence.

Climate Risk Disclosures: As suggested by RBI, a good starting point would be to use the prominent  “Task Force on Climate- related Financial Disclosures (TCFD)” set up by the Financial Stability Board which published its set of recommendations in 2017 to help businesses disclose risks and opportunities arising from climate change. SEBI has already set the ball rolling with its BRSR (Business Responsibility and Sustainability Reporting ) for large listed corporates making granular risk assessment easier for Banks. 

Forward looking REs will definitely look at opportunities arising from this crisis in terms of availing incentives for renewable energy production, consumer and investor loyalty by being in the forefront of environmentally sustainable businesses. Such REs can be encouraged to go beyond TCFD reporting and take up voluntary targets on Green Finance, Green Branches, Green Data Centres etc.

Sushil Muhnot was the former CMD of SIDBI and of Bank of Maharashtra. He is currently the Senior Advisor with CUTS International. Views expressed are the author’s own.