Indian banks face climate risks: Time for SBI to walk the green talk

Climate change is one of the biggest existential threats that mankind faces. While it can manifest in severe physical risks by causing more natural disasters, it also carries substantial financial and liability risks for the global financial system.

The European Central Bank’s (ECBs) climate risk stress test published in July 2022 shows that the EU’s financial institutions are grossly underprepared to tackle climate risks. This is despite the formal fossil fuel exit policies being in place for more than 100 financial institutions based in the region.

The Reserve Bank of India (RBI), in its latest discussion paper on climate risk and sustainable finance, flags this apparent risk to its regulated entities. The central bank intends to prepare a strategy based on global best practices for mitigating the adverse impacts of climate change, emphasising several areas. It provides guidance for the regulated entities to have appropriate governance, strategy and risk management structures to manage climate risks, explore forward-looking stress testing and climate-scenario analysis tools, and work on enhanced climate disclosures and capacity-building exercises.

The RBI intends to prepare a strategy based on global best practices for mitigating the adverse impacts of climate change.

The RBI recommends that regulated entities rely upon the Task Force on Climate-related Financial Disclosures (TCFD) framework, the most prominent climate disclosure framework globally, at least at the initial stage. The central bank’s proactiveness in addressing a sparsely understood risk and building internal capacity to address it is commendable and in line with the actions of several regulators globally.

The paper establishes that regulated entities must first assess the potential impact of climate risks and then implement plans to manage their exposure and mitigate them. State Bank of India (SBI), India’s largest bank, has been wary of the climate risks that it faces and plans to tackle them through a sustainability and business responsibility policy that it has formulated. The policy considers the wider environmental, social and governance (ESG) risks and opportunities the bank faces as part of its operations. The policy supports the bank’s risk management framework. Climate risks are also under its ambit. Further, to mitigate the interaction of credit risk with climate risk, the bank’s credit appraisal mechanism highlights the environmental risks that have a bearing on the borrower's operations.

While the policy is a move in the right direction, the bank must now walk the talk and realign its lending to manage climate risks. A close look at SBI’s loan book shows that in Q1 FY2023, advances to the petroleum and petrochemical sector (~US$5.5 billion outstanding as of Q1 2023) grew by 40% year-on-year. Secondly, most non-performing assets (NPAs) are from the retail segment, led by the agriculture sector (gross NPA ratio of 12.9% compared to 3.9% overall). These two sectors are among the most susceptible to climate risks in the economy. The petroleum sector is vulnerable to transition risks, arising from the switch to a low-carbon economy, and the agriculture sector to physical risks, emanating from changes to weather patterns or severe weather events.

More than 70 financial institutions globally have publicly committed to set emissions reduction targets through the Science-based Target Initiative (SBTi) across their portfolio. SBI has not stated any such ambition. Global investors, such as Blackrock and Norway’s Storebrand ASA, have scrutinised the bank to stop funding coal projects. Some investors, Amundi and AXA, have sold their holdings of the bank’s green bond after concerns regarding its ties to coal projects.

State Bank of India must now walk the talk and realign its lending to manage climate risks.

Such developments appear to have had an effect, at least regarding funding for thermal generation. SBI’s managing director Alok Kumar Chaudhary had recently disclosed that the bank is reviewing its approach to funding thermal power projects from the perspective of asset quality too. The bank’s overall power sector exposure, majority fossil fuel, has fallen over the last couple of years.

On the flip side, the bank is among the biggest domestic lender to the renewable energy sector, having deployed Rs397 billion (US$5 billion) to the sector to date, financing projects amounting to 19GW.  SBI believes that investing in sustainable businesses and practices can act as a robust tool to manage ESG risks cohesively. However, a loan book diversification towards renewables may not be a silver bullet to wade off climate risks to its portfolio.

A key to managing climate risks for SBI will be to adopt RBI’s recommendations, albeit in a phased manner. A formal strategy, governance and risk management framework specifically for climate risks will help in an institution-wide capacity-building exercise. It will also help identify areas like sub-par climate disclosures from borrowers and lack of proper definition of green economic activities, which act as roadblocks to properly implementing a climate risk strategy. These are also areas that would require further regulatory interventions. Further, the bank should also identify science-based metrics and targets to track to understand the climate risks and opportunities. SBTi’s guidance for financial institutions will be helpful here.

The article was first published by BQPrime.