Climate risks: Headwinds for banking

Scientists have for several decades been warning about the catastrophic implications of unaddressed climate risks and the repercussions from the world’s inability to limit average temperature increase to 1.5ºC above pre-industrial levels by 2050. “Climate action failure” still features among the foremost long-term threats, and its severity is increasing.

Both physical and transition risks anticipated from climate change are alarming. Lethal heat waves impact the quality of life, and have the potential to adversely impact food security, physical assets and infrastructure, and disrupt supply chains. These factors are also influencing evolving regulations, shifts in consumer demand, human habitation choices, and innovation and transition to low-carbon and climate-smart economies. For example, the universal call for reducing carbon emissions is impacting economically vital, but also highly carbon-intensive sectors such as oil and gas, real estate, automotive and transport, power generation, and agriculture.

For banks, climate-related risks manifest through traditional risk channels, such as due to 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 risks), legal and compliance risk related to climate-sensitive investment (operational risk), and reputational risk.

The Reserve Bank of India (RBI) has been responsive to global developments around. In 2021, it joined the Central Banks and Supervisors Network for Greening the Financial System — a voluntary group of 116 central banks that promotes the exchange of best practices on green finance. In July it released a discussion paper on climate risk and sustainable finance that addresses identification, management and disclosure of exposures to climate-related risks and capacity building within the banking sector. This paper should be seen as a precursor to having a banking system that integrates climate-related risks into its strategy and decision making.

There remain, however, existing and potential challenges that Indian banks face as they embark on this journey. The lack of a level playing field continues to be a challenge in integrating climate risk into mainstream governance, strategy, and risk management, as banks have limited ability to demand from their borrowers’ material data, or to enforce climate-related covenants beyond any compliance-driven mandates. There is also a lack of uniform taxonomy and clear mandated disclosure norms with standardisation of data that create significant information asymmetry.

Banks also face difficulties in attempting to measure their climate risks, as there is limited research available for reliable scenario building and quantification of climate risks. In addition, variability in methodologies adopted to identify climate-related risks makes comparability difficult. Skill-sets and capacities are also at nascent stages across the banking ecosystem.

As the inclusion of climate risks into mainstream banking continues to gain momentum in India, there are a few measures that can accelerate this development.

Formal support in building capacities of banks and their borrowers on climate-related risks, and their integration in overall strategy would help develop the required expertise. Redesigning priority sector lending  guidelines by including new climate mitigation activities could also be a consideration, in order to increase credit flow into such activities while contributing to building climate resilience at the grassroots economy.

That said, we are in the midst of several tailwinds that can support Indian banks in strengthening their climate risk management capabilities. The RBI’s discussion paper on climate risk clearly articulates the regulator’s current view and may be the foundation of future regulations. The Sebi-mandated Business Responsibility and Sustainability Report for the top 1,000 listed entities will foster greater transparency and enable banks to better identify and assess sustainability-related risks and opportunities, including climate risks. The green taxonomy for India that is under development will formalise green financing norms and support the Indian banking sector as it strives to play a leading role in helping India achieve its climate ambitions.

The writer is deputy managing director, Axis Bank