Context

• The article discusses the growing pressure to achieve climate-compatible growth as the world copes with the repercussions of legacy emissions.
• The article also highlights that fiscal and monetary authorities will now have to be cognizant (aware) of the feedback from climate change to the economy and suitably adapt their policy responses.

Risks to Financial Stability due to Climate Change:

• Climate change poses risks to financial stability in the form of:
  • Physical risks: Caused by extreme and slow onset weather events
  • Transition risks: Caused by changes in policy, legal and regulatory frameworks, consumer preferences and technological development and loss of asset value while transitioning to a low-carbon economy.
• Climatic events can impact overall financial instability owing to the following:
  • Supply chain disruptions and business continuity problems
  • Decreased labour productivity
  • Lower investment rates
  • Contraction in collateral values, defaults by businesses and households etc.

Global approach to promote green finance

• Prioritize credit flow: Central banks can guide the flow of finance by restricting the flow of credit to fossil fuel-dependent sectors.
• Approach: Central Banks also adopt a series of measures and best practices to streamline the flow of green finance.
  • For example, the Bank of Lebanon sets different reserve requirements for loans linked to energy savings.
  • The People’s Bank of China offers positive incentives to commercial banks for extending green credit.
  • RBI approach considers response based on understanding of the risk profiles of banks

India measures to streamline green finance

• Preferable lending: India includes renewable energy (RE) within priority sector lending (PSL).
• Global partnerships: In 2021, RBI joined the Network for Greening Financial System, a voluntary group of 116 central banks that promotes the exchange of best practices on green finance.
• RBI mandate: In recent years, the RBI has moved to acknowledge the risks climate change will pose to financial stability.
• Survey report: The Report of the Survey on Climate Risk and Sustainable Finance, released by RBI in July, 2022 seeks to understand preferred approaches to identification and disclosure of exposures to climate-related risks, frameworks for management of risks and capacity building within the banking sector.
  • It reflects that RBI prefers to tread carefully by assessing the preparedness of the system rather than indicate its own approach to what a central bank can do.
• RBI earlier acknowledgement of risks: In 2021, an RBI research paper demonstrated that extreme weather events can elevate inflation as was demonstrated by wheat prices this year.
  • RBI also set up a Sustainable Finance Group to coordinate with other national and international agencies on issues relating to climate change.
  • In 2022, RBI while estimating the exposure of Indian banks to green transition found that direct exposure of public and private banks to fossil fuel-based sectors, i.e. electricity, chemicals, and automobiles may be concerning.
  • RBI also noted that major private banks have not discussed the risks and opportunities related to climate change and sustainability which can be bad news for the government’s ambition to decarbonize the economy.

RBI challenges in mainstreaming green finance

• India’s differentiated position in the climate change battle: Rich countries and their institutions are marching ahead with their agenda of net zero emissions by 2050, which can hamper India’s developmental challenges in near future.
• RBI fixed mandate: The RBI is bound by a mandate fixed by the legislative and preamble to the Reserve Bank of India Act, 1934. It states that monetary policy’s “primary” objective is price stability, “while keeping in mind the objective of growth”. This could skew RBI’s attempts to foster a green financing compact within the Indian financial system.

Way forward

• Changes in climate-related policies: Climate related mitigation policies could include reduction in financial valuation or downgrade in credit ratings of businesses adversely affecting the climate or introduction of subsidies to encourage the use of energy efficient goods/processes.
• Task Force on Climate-Related Financial Disclosures (TCFD): To overcome climate-related risk, TCFD is an international standard for climate-related risk disclosure. It could be a good starting point for all stakeholders including investors and regulators and to bridge the asymmetric information barriers between banks and investors.
• Capacity building and training: The training linking climate change and finance across the board including senior management can potentially foster a culture of integrating climate change in all decision making.
• Mitigating risks: The risk to public borrowing from declining fossil fuel revenue also needs to be established.
• Forward-looking tools: Stress testing, climate scenario analysis etc. are forward looking tools which are used to assess the true risks of climate change rather than existing tools that are largely based on historical data, and do not capture the true climate change risks.
• Comprehensive assessment: A full assessment of macro-risks from disinvestment of fossil fuel-based assets requires a clear identification of the horizon for phasing down fossil fuels across sectors and an overall net zero plan for the disclosures to be used objectively is also needed alongside.