Indian financial system needs a green taxonomy for resilience to climate risks

Sustainable finance markets globally are grappling with two major issues – capital not reaching assets that need it the most and ‘greenwashing’. Both issues stem from weak policy frameworks and unclear implementation mechanisms.

Recent probes in Europe against DWS, Deutsche Bank’s asset management arm, and in the United States against Goldman Sachs regarding alleged greenwashing of their investment products are a case in point. Such cases highlight blind spots in the market. Their root cause is an unclear definition of green economic activities. This, in turn, prompts investment intermediaries to define sustainable assets arbitrarily.

Rapidly evolving sustainable finance markets are witnessing policy tools like green classification schemes called green taxonomies that provide a standard definition of green assets. These tools aim to increase financing of green projects, prevent greenwashing, and help develop a better understanding of the extent of climate risks faced by various financial sector intermediaries. 

The European Union (EU) and several countries, such as China, Malaysia, Mongolia, and South Africa, have recently established their green taxonomies. India’s taxonomy is still in the draft stage.

As the biggest owners of financial assets in India, banks and insurance companies will be at the forefront of effective taxonomy implementation in the country.

Banking sector perspective

With cumulative assets of US$2.5 trillion as of 2021, banks are India’s financing backbone. However, most of these assets do not align with India’s sustainability goals owing to the banks’ unpreparedness to manage the climate and broader environment, social and governance (ESG) risks. A green taxonomy would bring much-needed clarity. It would nudge banks to set sustainability targets and align their business strategies with them.

Evaluating exposure to sustainable versus non-sustainable activities is difficult for banks without a taxonomy. Hence, banks are unable to assess the climate risk in their lending portfolio. A taxonomy would help banks evaluate the use of loan proceeds and alignment of their lending portfolio with green activities. This will help disclose the alignment of their portfolio to the taxonomy, mitigate the risk of greenwashing, enhance their reputation, and provide credible data points to the Reserve Bank of India (RBI) for ascertaining climate risks in the overall banking system. 

Furthermore, the taxonomy-led disclosures should help expose the climate risks of non-green assets. Meanwhile, green activities will benefit from better pricing due to lower risks and, potentially, reduced capital adequacy requirements. The RBI, with a taxonomy as an important tool, can expedite climate risk discovery in the banking system and steer credit towards sustainable activities. Once climate and sustainability risks are correctly priced, green or sustainable activities could attract bank loans at more favourable terms.

A taxonomy provides a common language for banks and their clients, thereby improving engagement. To meet their sustainability targets, banks can nudge clients to adjust their businesses. Banks will also play an important role in advising clients about available sustainable finance solutions and building the required capacity to access them.

Insurance sector perspective

India is one of the most climate-vulnerable nations globally. It also has a growing and diverse insurance market with assets under management (AUM) of Rs49 trillion (US$636 billion) in the fiscal year (FY) 2020-21.

Domestic insurers have been weak in covering climate-related losses, and their climate disclosures are among the worst globally. As long-time risk managers, risk carriers and investors, insurers would benefit from a green classification system to ascertain assets with little contribution to climate risks. In doing so, they can promote stable investments in their portfolio and insurance underwriting practices.

On the liability side, without a green taxonomy, an unclear understanding of climate affected/aligned economic activities may deter the modelling and pricing of climate risks in underwriting.

Insurers underwriting risks in fossil fuel-aligned sectors like thermal power generation may face a scarcity of reinsurance cover from foreign firms. This is because insurers in jurisdictions like the EU are increasingly cutting cover for carbon-heavy sectors. Repricing insurance products for these sectors in alignment with emission thresholds established for taxonomy-aligned activities would become important. In 2019, a 3x increase in the cost of insuring power projects irked domestic thermal power generation companies, something which could happen more frequently.

On the asset side, there are two main climate change-related problems. First, impairment of asset values due to physical and transition risks will cause equity price shocks. Second, the deteriorating creditworthiness of borrowers will tank bond prices. India’s largest insurer, Life Insurance Corporation (LIC), has 16% of its equity investments in energy companies that are highly susceptible to transition risks. A green taxonomy will help insurers better understand the potential impact of individual investments on their portfolios.

As India marches towards energy transition, its financial institutions require a science-backed green taxonomy for resilience to any unintended consequences of climate risks. However, the central bank and the insurance sector regulator must work together to successfully launch and implement a green taxonomy.

The article was first published in ETEnergyWorld.