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Environmental Disclosures: Imperative for Financial Institutions

, March 7, 2023, 0 Comments


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 a nation. Climate change has been recently recognised as an emerging source of risk for the financial system. Severity and timing of climate and environment related impact also pose a challenge for the soundness and safety of individual financial institutions / entities and in turn the stability of the overall financial system. Hence, it has become imperative for the financial ecosystem to manage the risks and opportunities that may arise from environmental degradation and a changing climate.

Climate risk manifests its dangers on the financial stability of the ecosystem in two ways: Physical Risks cause direct harm to assets or disrupt Industry / company value chains and by way of Transition Risks that arise from the overall shift to a low carbon economy through changes in policy, technology and market sentiment as banks try to adjust towards a low-carbon economy. Apart from credit quality, climate risks also have an impact on market and operational risks of the banks.

Another important dimension for the financial entities is the reputational impact. This is something which affects financial entities more indirectly. Reputational concerns arise when customers financed by the financial institutions carry on business activities which have an adverse environmental impact.

The good news is that the financial institutions have started recognising the threat that climate change poses to their overall wellbeing. Globally many investors have already started to move away from firms which generate greater environmental costs or engage in activities which are likely to cause environmental harm.

While globally it is a much accepted pattern of FIs investing in environmentally friendly businesses, however in India, this narrative is still shaping up. FI communities in India have increasingly started to be aware about their lending and investment decisions.

Also, there is a growing sense of responsibility in India Inc about the projects that they build up like how green, brown and red they are. This automatically leads to them disclosing their environmental footprint.

Environmental Disclosures are an effective tool to increase and measure transparency and accountability in the issues that include immense environmental importance. The crux of any non-financial reporting framework is to encourage better corporate decision-making and long-term value creation using transparency. Increasing the level of environmental disclosure is a vital first step to ensure we are able to avert the worst impacts of climate change and finance the green transition which is very much high on the agenda for India.

Over the last few years, several central banks and financial supervisors across the globe have recommended investors and financial institutions to assess their exposure to climate-related financial risks. Central banks and financial supervisors have also started to design scenarios for climate stress tests to assess how vulnerable the financial system is to climate change. The IPCC report has also made it straight that no one will escape the consequences of global warming and environmental desecration. That means solving the climate crisis no longer rests just on the shoulders of the largest actors in the world. Financial institutions have a real role to play to drive necessary changes in the real economy.

The risks to banks and other financial institutions are real and many researches have shown that climate change leads to stranded asset risk. Recent RBI’s Discussion paper on Climate Risks and Sustainable Finance has underpinned the importance of managing climate risks for Indian REs and has reaffirmed that environmental management will increasingly become a top priority for Indian banks in times to come. The paper has also recognised the importance of climate related disclosures by regulated entities and has advised them to explore aligning their Climate-related Financial Disclosures on the lines of the FSB’s TCFD framework.

CDP (formerly known as Carbon Disclosure Project) questionnaires on Climate Change, Forest and Water security are 100% aligned with TCFD already and will set the right base for Banks/ Financial Institutions to disclose and build an understanding of the nuances involved. It is good to see that momentum is being built up in the policy makers side and being translated into sound policies thereof.

The 11 Financial Institutes disclosing their environmental footprint to CDP have reported the Financial Impact of INR 1145 billion accruing to climate change. Potential driver that have financial and strategic impact on their businesses are identified as Carbon pricing mechanisms, Regulation and supervision of climate-related risk in the financial sector, all climate linked disasters, Write-offs, asset impairment, and early retirement of existing assets due to policy/regulatory changes, Enhanced emissions-reporting obligations, Substitution of existing products and services with lower emissions options, inability to attract co-financiers and/or investors due to uncertain risks related to the climate, Increased stakeholder concern or negative stakeholder feedback among others.

On the other hand, Financial Opportunity to the tune of INR 1033 billion has been reported as well in form of the development of new revenue streams from new/emerging environmental markets and products, Access to new markets, Development and/or expansion of low emission goods and services, Digital Transformation, Reputational benefits resulting in increased demand for goods/services, Development and/or expansion of low emission goods and services, Development of climate adaptation, resilience and insurance risk solutions, Shift in consumer preferences, Use of lower-emission sources of energy among others.

Also, if the RBI mandates the banks to undertake climate stress testing of their portfolio (which is also discussed holistically in the paper), Indian banks and FIs will be asked to disclose from now and beyond. RBI paper recognises that while most banks and FIs may be less ready at this stage to report Scope 3 emissions (financed emissions) or concentrations of credit exposure to carbon-related assets, they should start chalking out a plan to obtain relevant information such as by collecting emission data from their customers. Calculation and reporting of scope 3 emissions remains a major hurdle for several financial institutions because of the complex nature of the business and variety of sectors to which lending is being done.

Banks must also prepare to limit their future financial losses due to climate change. Phasing out fossil fuel investments and exposure to high carbon sectors is key to managing longer-term financial impact. Without a clear climate strategy in place, raising global capital will also increasingly become more difficult and expensive.

Hence in conclusion, the growing sentiments in Indian regulator and policy maker side is evident that Financial Institutions will have to take a lead in setting larger examples for India Inc to follow in disclosing their footprints accruing to environmental damage. It is high time that financial institutions need to disclose and increase the financing levels for projects aligned to climate change action. Collective engagement would help build on early progress and go a long way in addressing the challenges of climate change.