Wednesday, February 8, 2023

Climate for Change

In a proposal to make India’s financial system resistant to climate-connected risks and assist Regulated Entities to deal with matters of a warming planet, the Reserve Bank of India is mulling over potential rules and regulations.

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By Shivanand Pandit

Climate change has a tremendous influence on the financial sector, either owing to physical risks such as a decrease in the value of collateral due to climate change happenings such as floods or due to transitional risks such as the downgrading of credit rating of high-emitting business establishments. In a proposal to make India’s financial system resistant to climate-connected risks and assist Regulated Entities (REs) to deal with the matters of a warming planet, the Reserve Bank of India (RBI) is mulling over potential rules and regulations.

As a start, the central bank published a discussion paper on climate risk and sustainable finance in July 2022. At the same time, it also issued a survey report to underline whether commercial banks in India are equipped enough to cope with risks linked to climate change.

Regulated Entities (REs) refer to all kinds of banks given a license under Section 22 of the Banking Regulation Act, 1949, financial institutions, non-banking finance companies, payment system providers, and all authorized persons, including agents of Money Transfer Service Schemes (MTSS), etc. The RBI, while announcing the monetary policy decision in April 2022, had admitted that climate change may bring about physical and transition risks that could have consequences for the security and reliability of individual REs along with financial stability. The RBI also mentioned that such entities should develop and execute an accurate method for understanding and evaluating the prospective effect of climate-related financial risks in their business schemes and activities. RBI Governor Shaktikanta Das said that climate-related risks would be a focus area in times to come and the central bank would want to work on it collaboratively.

The discussion paper begins with a summary of climate-related risks to financial steadiness. It conceptualizes comprehensive advice for all REs to integrate accurate governance procedures and policies to lessen several climate-related risks. Further, it raises significant queries on the detection of climate risks and the incorporation of the climate risk management outline.

The main features of the guidelines are the instant urgencies in shaping policy discourse, the way ahead for the governing policy outline, chief challenges in incorporating the climate risk outline in governance, the overall timeline for execution of the disclosure outline, and possible challenges in developing climate risk stress testing and a situation analysis structure.

The paper also trusts the Task Force on Climate-Related Financial Disclosures (TCFD) suggestions, namely a climate-connected disclosure structure with an emphasis on four thematic zones—governance, strategy, risk management, and metrics and targets. The disclosure should be done as per the standards set by the TCFD which has been created by the Financial Stability Board, an international body to supervise the international financial system.

Further, the central bank has suggested that voluntarily, the REs should set up aims for intensifying funding to green projects over short term, medium term and long term towards certain identified sectors. The discussion paper mentioned that to green the banking procedures by making them extra environment-friendly, the REs could consider changing their branches to green branches by abolishing the use of paper in their functions and introducing the option of e-receipts at their ATMs. As per the discussion paper, the REs may look at avenues and methods to incentivize acceptance of e-receipts and may like to alter all their data centres to green data centres by converting to renewable energy for sourcing power for the data centres and execute advice given by established frameworks like the Green Data Centre Rating Systems.

The RBI also mentioned in the discussion paper that there is a rising necessity to alert India’s financial sector about the significance and merits of green finance with a special focus on capacity building and creating an understanding of climate risk and sustainable finance to attack the challenges created by climate change. To address the capacity-building necessities, the discussion paper also proposed that the Indian Banks’ Association (IBA) may establish a working cluster on capacity building in the area of climate risk and sustainable finance. The paper also added that the board of directors of the REs would have to play a crucial role in recognizing climate-linked and ecological risks as well as opportunities and judging the real and prospective influence of these risks on their policies and plans.
Along with the discussion paper, the RBI also issued a report of the survey carried out by the Sustainable Finance Group in the Department of Regulation in January 2022 to gauge the approach, level of readiness and progress of commercial banks with regard to climate-related risks. In the survey, the RBI involved a total of 34 commercial banks, including public sector banks (PSBs), private sector banks and foreign banks operating in India. The survey revealed that PSBs are least prepared, as of now.

Outside this general comment, PSBs were found trailing behind on almost all norms like risk management, governance, climate-related financial disclosure, human resource-related capacity building, internal green initiatives, etc. The survey has disclosed that almost all foreign banks and a small number of the private sector banks have a distinct department or business vertical for sustainable finance.

Thorough scrutiny of the discussion paper reveals that it has many exciting pronouncements and a heap of counsels, but also a lot of zones where it falls short. Let us begin with the good things first. The paper underlines breaches in the manner climate change as a significant danger is considered by India’s banks. Although many banks have not judged climate change as a significant danger, the risk is considered for Internal Capital Adequacy Assessment Process (ICAAP), which is not combined with the general risk management practice. This can be bad news for the government’s goal to decarbonize the economy.

There are also a few opinions laid out on how private banks can cope with climate change risk and expand green finance. This covers many zones comprising governance, strategy, risk management, reporting and disclosure as well as capacity building. For instance, the suggestion of estimating climate risks through ICAAP and mixing climate change with the overall risk management framework will aid banks’ resilience against this looming risk.

Another significant feature is on disclosure requirement, which is a decent starting point for all stakeholders, including investors and regulators. To link the unbalanced information blocs between banks and investors, the paper gives a solid push to follow the benchmarks set by the TCFD. The focus on capacity building and coaching on climate change across the board comprising senior management can go beyond connecting the skill gap and possibly promote a culture of combining climate change in all decision-making. Another pragmatic suggestion is to embrace forward-looking instruments such as stress testing and climate scenario analysis to measure the genuine risks of climate change.

Prevailing instruments are mainly based on historical data and do not capture genuine climate change risks.
Now let us look at the dark side of the paper. One prominent absence in the consultation paper is the central banks’ forthcoming plans on climate change and sustainability in the background of the central bank’s role in financial stability and regulatory practices. The paper quoted the Financial Stability Board’s emphasis on regulatory and supervisory methodologies. However, the Network for Greening the Financial System (NGFS) paper clearly states that climate-linked risks fall within the banking supervisory and financial stability directives of central banks and financial supervisors. It would have been beneficial if the RBI had come up with macro-prudential supervision ways regarding climate change. Another big skip is a debate and outline for the consideration of climate and sustainability risk in monetary policy. This is beginning to draw the attention of the policy and academic community, but is missing in the paper.

Also, to quicken good practices, the watchdog could have used its power more. For example, in place of fixing a voluntary funding aim for green finance, the RBI can make it compulsory for banks to distribute a precise percentage of advancing to green finance by adjoining green business under the priority sector lending (PSL) category. The RBI can guarantee adequate debt capital flow to green businesses by fixing a minimum percentage for them within PSL. The paper could have roofed areas that go beyond reactive steps to proactive ones. For example, banks can incorporate phrases associated with climate change in the loan documents such as covenants that would compel the borrowers to take calculated actions. The terms of loans can be connected with adherence to the phrases. Banks can also engage with their customers and aid them in their sustainability policy and follow best practices.

Although the paper states liquidity risk because of climate change, it does not offer means to tackle it. One choice may be for banks to take into account sustainability risk in their liquidity risk management process. The banks’ liquidity ratios can be adjusted by taking sustainability into account, through a differentiated risk-based approach. In addition to the recommendation to improve knowledge, the paper can also specify the roles and responsibilities of the team members, including the senior management involved in sustainability strategy. There can also be a system for reward. For example, the compensation configuration of top management can be associated with banks’ approach to climate change like the carbon intensity of lending portfolio and carbon emission from the direct operation. Taking cognizance of the fact that diverse sectors that banks advance to may face massively different vulnerabilities to climate risk, there can also be some thought given to sector-specific policies. Banks can develop and implement minimum standards for each sector.

—The writer is a financial and tax specialist, author and public speaker based in Margao, Goa

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