Climate change; biodiversity loss; soil, water, and air pollution are amongst the environmental damages that are threatening human well-being and sustainable livelihoods up-close. Having said that, these degradation elements pose significant risks to economic activity and threaten macro-financial stability. This financial system is the backbone of any economy because the efficiency with which the financial system works from lending to investing, plays a very important role in the economic development of any nation. Financial supervisors and market participants across the globe have now come to realize the financial risks that climate change and other environmental challenges pose and the dire need to mitigate these risks.
To enhance transparency and facilitate the analysis of climate- and environment-related risks, sustainability related financial disclosures have become an imperative for mobilizing sustainable finance. The Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) has been the bedrock for promoting disclosure.
The TCFD highlights the importance of transparency in pricing risk, including risk related to climate change, to support informed and efficient decisions on capital allocation. Acknowledging the importance of nature and biodiversity related financial risks, Taskforce on Nature-Related Financial Disclosures have come out with a set of recommendations towards integrating climate and nature related reporting in business operations.
In the face of significant macro-financial risks stemming from climate change and other sustainability risks, monetary and financial authorities have started to develop sustainable finance policies, guidelines and frameworks for mitigating and managing these risks and for scaling up sustainable finance. Financial markets are also starting to integrate sustainability risks in investment and lending decisions.
The sentiment in emerging economies is also shaping up whereby they have taken different approaches on macro and micro prudential measures. In India, the Reserve Bank of India has joined The Network of Greening the Financial System (NGFS) and actively participating to producing research and tools to manage climate risks.
Last year we also saw the rolling out of a consultation document by the RBI on climate risk and sustainable finance. As a follow up to that, RBI is also building regulatory guidance on climate scenarios, stress testing, and climate-related financial disclosures by regulated entities. Additionally, it has introduced a framework for green deposits and has advocated the need for a national sustainable finance taxonomy. Securities and Exchange Board of India has come out with BRSR core and has included the value chain partners in sustainability reporting, has expanded the ambit of green bonds to blue and yellow bonds.
It is encouraging to see the growing interest of the Indian financial sector on the assessment leading to the accounting climate risks in balance sheets and in lending decisions. This is the need of the hour, given the ever-evolving space of climate risk assessment globally and in India. However, stronger involvement of the financial institutions will drive a more vibrant agenda for investors to include climate risk as a driver for lending and investments. The lack of consistent methodologies, cost implications translating into reporting burden, and complicated review/verification procedures has contributed to the slow incorporation of undertaking climate risk assessment holistically in the Indian financial sector.
However, major challenges remain. Despite rapid growth, sustainable lending and investment still account only for a small fraction of the total lending. Literature shows that financial markets continue to finance investments that undermine the achievement of the Paris Agreement’s objectives and the SDGs. Focusing on short-term returns and ignoring the long-term risks to nature and society could be one reason for this mismatch.
Few imperatives for India
Enhanced Disclosures by Financial institution (FI) community especially on the financed emissions. More and more FIs in India should come forward and disclose their environmental footprint to gauge where they stand in terms of taking climate action and meeting the Paris agreement goals. Good disclosures also mean ease in attracting foreign capital and ease in which they are able to approach international markets. Strong regulations are needed to ensure that financed and portfolio data is readily available at Banks’ disposal easing them to undertake climate stress testing. Firms must also report on relevant approaches and policies for disclosure used to meet the transition targets such as the internal carbon price used, and the characteristics of carbon credits or carbon offsets among others.
Financial Institutions must engage with companies, access their data and thereby align their portfolios with net-zero- To put the money in the right company which is “green”, the investors need to use the environmental data disclosed by the corporations to make environmentally sound decisions. Disclosures can be used best to understand a company’s strategy in dealing with climate change, deforestation and water security risks, the risks they face, and the subsequent disclosure’s opportunities. The protection of capital is very much important i.e. the companies that FIs are lending to, because at the end of the day banks need to protect the capital and build wealth for their stakeholders. By using the data, financial institutions can take real and rapid action to align their portfolios with a net-zero emissions, nature-positive economy.
Leveraging on the climate risks- There is an associated risk imperative as bank’s need to internalise risks to avoid any impact on their balance sheets but there’s also a business imperative that banks should not miss on any opportunity brought out by the transition.
Sustainable Finance taxonomy is the need of the hour- The lack of commonly agreed definitions of what constitutes sustainable lending and investment practices contributes to the fragmentation of sustainable finance markets and holds back their development. A standardization of green finance practices also helps to impede greenwashing, i.e., making misleading claims about environmental impact or the performance of financial products. Policymakers and regulators should support sustainable lending and investment by developing a sustainable finance taxonomy of economic activities which is interoperable and comparable across jurisdictions.
Transition Finance framework- Businesses and sectors which deal with “not so green fossil fuel industry” often face difficulty in raising finance. For them to access financing to enable their transition to net-zero emissions, an efficient transition finance framework can be established by the authorities and policymakers. The framework can go a long way in assisting them in reducing the potential negative consequences of a disorderly shift, such as transition risks related to the change in environmental policies, limited access to inexpensive and dependable energy, unemployment, and other social implications leading to a just transition in broader terms.
International cooperation among cross-border monetary and financial authorities through forums such as the NGFS is also needed. RBI’s joining of NGFS is indeed a welcome step which will help it learn from best practices in sustainable finance and banking domains across the world.
Capacity building is very critical and important. It is important to understand how a bank/FI will measure environmental data and put it into use. Hence, there is a need to boost capacity building in order to increase reporting standards so that disclosures are not just a practice of greenwashing.
SMEs interaction with sustainability goals- Getting SMEs on board with respect to climate action journey can be challenging. SME (supply chain) financing is another crucial aspect that is emerging in India. Disclosures should also be promoted for unlisted companies such as MSMEs. A strong policy push to focus is needed on that as well. Nonetheless SEBI’s latest BRSR Core framework for listed value chain partners is a welcome step and can be a stepping stone for other value chain companies to follow in near time.
Private sector involvement
The crucial role of private climate finance in complementing public climate finance and promoting the creation of financing mechanisms, such as blended finance, de-risking instruments, and green bonds for projects, has also emerged as a significant requirement in India
