The possibility of the irreversible adverse effects that may be unleashed by climate change, some of which the world is already witnessing, loom large. RBI’s Discussion Paper on Climate Risk and Sustainable Finance broaches the impact that climate change may have on the financial sector. While drawing a link between climate change and financial transactions may not be apparent, the threat of the former on the latter is, in fact, quite obvious. One example of this is a collateral underlying a loan losing its value due to floods which may be caused by climate change. This is, in fact, an emerging possibility in states like Uttarakhand and Himachal Pradesh. Shifting investor sentiment to invest in green financial products on becoming aware of the adverse impacts of climate change is another example. In a recent report by the Climate Policy Initiative, which tracks green investment flows, India falls short in its climate investment targets by a staggering 75%.
Against this backdrop, RBI’s Discussion Paper becomes even more relevant and timely. Primarily, it sets out the climate-related financial disclosures that regulated entities (REs) of RBI may be required to make. They appear to be largely in line with the framework set out by the Task Force on Climate-related Financial Disclosures (TCFD) established by the Financial Stability Board and cut across governance, strategy, risk, and metrics-related disclosures. While the proposed framework in the Discussion Paper is an apt signal to the financial sector to take climate risk more seriously, there are two areas that could do with some more work.
Need to define what is green
In the context of the Discussion Paper, to facilitate the RE in making the above disclosures, it will be foundational to determine whether its lending or investment activity is linked to climate change mitigation or adaptation. With respect to green financing generally, the foremost question that will arise is whether the financial product or project in question is sufficiently green to qualify as a ‘green investment’. To make this determination, a common understanding as to what qualifies as ‘green’ is necessary, which India currently lacks. Further, the understanding of the term should be common not only for the financial system of India but should be aligned with international standards so as to promote cross-border investments and boost investor confidence.
International precedents in this regard are the green classification systems developed by the European Union as well as South Africa. They define sustainable or green economic activities as those which significantly contribute to defined environmental objectives (such as climate change and pollution control) and comply with technical screening criteria to be conducted by the financial entity. For example, climate change mitigation is a defined objective, and for sectors such as manufacturing (for example, cement), the screening takes into account industry-specific factors, such as significant CO2 emissions and the potential to contaminate soil as well as groundwater.
As the process of defining green investments is in its nascent stage, the time is just about right for developing such a system or taxonomy. However, some of the challenges may be difficulty in classifying general credit facilities, which may not have a specified purpose (and thus cannot be taxonomy-aligned), and lack of granular data to assess alignment with the taxonomy.
Enhanced role of RBI
On an overview of the Discussion Paper, it appears that RBI can take on a greater role in the regulation of climate risk. This could be done in four ways: first, it can provide more tangible guidance. For instance, while the Discussion Paper mentions that banks may require accounting for climate risk while determining capital adequacy under the Basel norms, it does not provide guidance on how the same can be done. Further, rather than placing the onus on the RE to determine their own capability in terms of disclosure, the regulator may lay down a tailored approach based on size and activity of the RE. Second, the regulator can adopt a proactive approach and lay down best practices that may be adopted by REs, such as assisting their borrowers in transitioning to carbon neutrality by providing bespoke advisory services and capacity building. Third, it can use fintech for exploring initiatives to boost green financing by building data repositories and platforms which assist in simplifying and aggregating data as well as matching investors with green projects. Lastly, RBI can lead by example by making climate-related financial disclosures in line with the proposed framework, even though it is not meant for central banks. The Bank of England is the flag-bearer in this regard, and the regulator may emulate this unique initiative to truly walk the talk and, in the process, apply its learnings first-hand to fine tune the evolving policy framework on climate risk.
The writer is lead and senior resident fellow, Vidhi Centre for Legal Policy, New Delhi