How Reserve Bank of India can play a role in building resilience against climate risks

If pandemics and wars were not enough, central banks have to battle another looming threat to financial stability. Climate-related risks can plague the financial system and even amplify existing risks if central banks are unprepared.

How can the Reserve Bank of India (RBI) prepare for this clear and present danger? The RBI’s supervisory role lends it several tools to foresee and combat such risks. One such tool is scenario analysis and stress tests of the banking system.

Authorities worldwide are exploring climate scenario analyses and stress tests to better understand climate-related risks. Recently, the European Central Bank (ECB) conducted its maiden climate test with startling results. A sudden jump in carbon prices along with floods and droughts this year would lead to losses of at least US$71.1 billion for the Eurozone's biggest banks.

Several other central banks, such as those in France, the UK, Germany, Japan, China, Netherlands, Finland, and Malaysia, have also conducted or are planning to conduct scenario analyses and stress tests to check the resilience of their financial systems to climate risks.

Authorities worldwide are exploring climate scenario analyses and stress tests to better understand climate-related risks.

While the RBI has highlighted climate change-related issues in the past, it has not done any climate scenario analysis or stress tests for the financial system to date. The central bank is soon going to issue a consultation paper on climate change-related risks for financial institutions, indicating that it is actively working on combating this risk.

Climate-related risks are a source of financial risk

Climate risks interact with the conventional ones for banks, namely credit, liquidity, operational and reputational risks, amplifying them further. For instance, lending to the thermal power generation sector carries substantial credit risk. This is because higher carbon taxes, demand substitution with lower emission options, increased raw material costs and reduction in capital availability all seep into higher default probabilities by counterparties.

Several imported coal-based thermal plants in India are at or near coastal areas. These are susceptible to the physical risks of climate change through rising sea levels and the increased severity of extreme weather events, such as cyclones or floods. This again is a potential source of credit risk for banks lending to such plants.

A robust climate-related disclosure framework needed

A pre-requisite to conducting such supervisory exercises is collecting climate-related data from financial institutions for risk identification and measurement. Mandatory climate-related disclosures are fast becoming a reality across jurisdictions. Several of these disclosure requirements align with the Task Force on Climate-related Financial Disclosures (TCFD).

The G-7 last year committed to making TCFD reporting mandatory. Countries such as New Zealand, Japan, the UK, Hong Kong, Switzerland, Canada and Malaysia are mandating TCFD-aligned or TCFD-inspired climate disclosures.

Climate risks interact with the conventional ones for banks, amplifying them further. 

The TCFD framework has four thematic areas – governance, strategy, risk management, and metrics and targets. For example, under the strategy recommendation, organisations need to disclose the resilience of their strategy to a 2°C or lower scenario. TCFD provides supplemental guidance for banks and other financial institutions across these four areas.

Leveraging global experience in TCFD implementation and scenario analysis

TCFD is supported by 110 financial regulators, including 50 central banks, and 2,600 organisations globally follow its regulations. This provides several learnings for Indian banks. RBI is also a part of the Network for Greening the Financial System (NGFS), a group of 114 central banks and financial supervisors aiming to share best practices, contribute to the development of environmental and climate risk management in the financial sector.

NGFS has developed four standardised climate scenarios that central banks can use as a starting point. RBI can learn from other central banks that have already run climate tests using scenarios from NGFS and disclosures per TCFD.

Mandating climate disclosures for banks as part of BRSR reporting

India already has a sustainability disclosure standard in place, the Business Responsibility and Sustainability Reporting (BRSR) standards. While BRSR focuses on the wider environment, social and governance (ESG) disclosures, TCFD concentrates on climate-related disclosures. BRSR also does not include scenario analysis, which is an important part of TCFD. Better coordination between the RBI and the capital market regulator Securities and Exchange Board of India (SEBI) can help mandate climate-related disclosures for banks as part of their BRSR disclosures.

RBI can learn from other central banks that have already run climate tests.

TCFD aligned disclosure by banks will not only provide data points to RBI but also to other stakeholders such as investors to assess a banks’ standing from a climate risk lens. It will also help ensure banks consider climate risks while lending and launch green financial products to de-risk their loan books. This will increase the uptake of green credit and financing for low-carbon activities, helping India achieve its climate goals.     

Phased implementation will help banks prepare for TCFD standards

TCFD implementation has not been easy for banks. According to a survey of global banks’ TCFD disclosures, scenario analysis is still evolving. Banks are yet to fully quantify the climate impacts on their strategy.

Companies struggle to collect, collate and analyse detailed emissions-related data in all areas of their operations. For banks, this becomes trickier when they have to disclose financed emissions.

Therefore, RBI should let banks disclose TCFD-aligned information in a phased manner to help them get accustomed to the nuances of climate reporting and climate-related scenario analysis.

This article was first published in The Economic Times.