The big green reset: Major changes are afoot in the credit markets

As the transition to a low-carbon economy gathers pace

On January 25, we will cross a key milestone: The Reserve Bank of India (RBI) will conduct the first ever auction of sovereign green bonds (SGrBs). Two securities for a cumulative Rs 8,000 crore will be on sale — five- and 10-year SGrBs, each for Rs 4,000 crore. (The proceeds are to be deployed in government projects that aim to reduce the economy’s carbon footprint.)

In FY24, we may be on the cusp of a noticeable shift in the way credit is appraised and extended. A green taxonomy is in the works — to help lenders better assess climate risks in their books, scale up green and sustainable finance, and mitigate the risk of “green-washing.”

Speaking at the Business Standard BFSI Insight Summit in Mumbai (December 22, 2022), RBI Deputy Governor M Rajeshwar Rao said: “A formal definition of green finance along with a taxonomy is the need of the hour, as it would enable more precise tracking of finance flows to green sectors in India, which in turn would help design effective policy, regulations and institutional mechanisms directed towards increasing both public and private investments.”

Progress towards a low-carbon economy has quickened. The SGrB auctions come within three months of Finance Minister Nirmala Sitharaman finalising the sovereign green bonds framework last November. It followed the RBI’s Survey on Climate Risk and Sustainable Finance in July 2022, and the Securities and Exchange Board of India’s reporting architecture on sustainable finance a month later.

On the green road

Green Finance in India: Progress and Challenges, a paper in the RBI’s January 2021 monthly bulletin (by Saurabh Ghosh, Siddhartha Nath and Abhishek Ranjan of the central bank’s Department of Economic and Policy Research) observed that “the cost of issuing green bonds has generally remained higher than other bonds.” The average coupon rate for green bonds issued since 2015 with maturities of five to 10 years has been higher than those on corporate and government bonds of similar tenure.

Now, the pricing at the maiden SGrB auctions next week will set the benchmark for India Inc’s green bonds, as such issuances will have a mark-up over SGrBs. This will be keenly watched, since it will have an impact when India Inc draws up its capex ambitions for the decades to follow. And we are in completely uncharted waters.

“Even globally, much of the carbon accounting methodologies are still evolving. There is also a chasm on climate risk — where environmental scientists don’t understand finance well enough and finance professionals don’t completely understand the science,” said Deepak Parekh, chairman of mortgage lender HDFC, while speaking at the 21st World Congress of Accountants on November 21.

He added: “I have heard many laments saying that lack of climate and emissions data is the biggest hindrance. Yet, hiding behind lack of data is not an excuse. There is no reason why the Indian financial system, for instance, cannot collaborate together on climate risk and measuring financed emissions.”

Just what is the pain for banks?

“Climate-related risks are manifesting through traditional risk channels,” says Rajiv Anand, deputy managing director, Axis Bank. These include the borrower’s inability to repay loans (credit risk); reduction or re-pricing due to climate regulation (market risk); reduced access to funding due to changing market conditions (liquidity risk); legal and compliance risk related to climate-sensitive investment (operational risk); and reputational risk arising from changes in market and consumer sentiment.

“There’s a lack of certainty about the severity and frequency of these risks, making it even more important for banks to proactively identify and manage the risks and opportunities that are arising from climate change,” Anand adds.

The transition will vary across sectors.

“While India is working on a specific taxonomy, it’s not an issue when it comes to lending to green sectors like solar LED lighting or electric vehicles,” notes Govind Sankaranarayanan, co-founder and chief operating officer, Ecofy — a new-age “green” shadow bank. “But yes, when it comes to other sectors, like pharmaceuticals, then taxonomy becomes critical. One can always look at the way the European Union (EU) has gone about it until we have our version of a taxonomy.”

Incidentally, the Hong Kong-based Asia Securities Industry & Financial Markets Association released its first Green Taxonomy Survey last month on the common themes and issues in sustainable finance in the Asia-Pacific region and beyond — 75 per cent of the respondents were using a taxonomy with the EU Taxonomy of Sustainable Activities dominating.

A lot is at stake as we take the green path.

The 2023 ESG Outlook from Moody’s Investors Service, an analysis of the transition plans of rated non-financial companies, suggests that those most exposed to carbon-transition risks are the least likely to disclose ambitious and detailed carbon-transition plans, making them least prepared for increased scrutiny of corporate transition plans, and the associated credit implications.

Its data shows that few rated companies in the oil and gas, mining and agriculture sectors disclose such plans. And “this may, in part, reflect the financial and technological challenges that entities in these sectors face in cutting their emissions, and the legal actions they may expose themselves to if they set ambitious targets that they cannot meet.”

“Companies could see their cost of capital increase if investors lose confidence in their ability to manage the transition,” says Rebecca Karnovitz, vice-president (senior credit officer), Moody’s Investors Service. “In our latest environmental risk heat map, 16 sectors with $4.9 trillion of debt have high, or very high inherent exposure to carbon-transition risk. These sectors include oil and gas, regulated and unregulated electric utilities, automotive manufacturers, chemicals, steel, shipping and airlines.” 

In effect, transition costs will be passed on to the end-user as pricing across the supply chain gets impacted. It would lead to elevated social risks for a range of public and private entities owing to high cost-of-living concerns, and heightened refinancing risks for lower-rated issuers for which governance attributes tend to weaken resilience to external shocks — even as the macroeconomic, financial and geopolitical fallout of the pandemic and the Russia-Ukraine conflict continues to exacerbate ESG (environmental, social, and corporate governance) risks.

The RBI’s Financial Stability Report (FSR, July 2021) observed that a cross-industry disciplinary forum is needed to launch a comprehensive climate risk assessment. A key prerequisite is to develop emission reduction pathways for energy-intensive sectors, map them onto macroeconomic and financial variables, and integrate them with quantitative climate risk-related disclosures to develop a holistic approach to addressing the financial stability risks arising out of climate change.

Welcome to the world of green finance.