Heed to Heal - Climate Change is the Emerging Financial Risk1
(Keynote Address delivered by Shri. M. Rajeshwar Rao, Deputy Governor, Reserve Bank of India -
Thursday, September 16, 2021 - at the CAFRAL Virtual Conference on Green and Sustainable
Finance)
1. A very good morning to all of you. I am thankful to CAFRAL for having given me
an opportunity to interact with the participants of the Virtual Conference on Green and
Sustainable Finance.
2. The theme of today's Conference i.e., Green and Sustainable Finance is highly
contextual. While the pandemic brought in a myriad set of challenges for the
authorities around the world in framing and implementing policies for supporting lives
and livelihoods, it has also given us time to pause, reset and reflect on several things
including the issue of providing a sustainable, greener and better future for our
succeeding generations. The impact of climate change is increasingly seen and felt as
it plays out across the globe in different forms be it floods in the United Kingdom,
heatwaves and wildfires in Canada and Australia or natural calamities in various parts
of India. This Conference organized by CAFRAL gives us an occasion to gather our
thoughts and brainstorm on the road ahead on this critical issue.
3. Climate change is possibly the biggest threat staring at the face of humanity. How
we tackle this challenge will be a defining moment of our times. The latest report of
the Intergovernmental Panel on Climate Change2 (IPCC) released last month has
further highlighted the need for urgent action in addressing climate change. The report
is a stark reminder for all nations that unless we start taking remedial actions urgently,
the world is in for difficult times.
4. Let me try to drive home this point by quoting from the report:
"We can't undo the mistakes of the past. But this generation of political and business
leaders, this generation of conscious citizens, can make things right. This generation
can make the systemic changes that will stop the planet warming, help everyone adapt
to the new conditions and create a world of peace, prosperity and equity. Climate
change is here, now. But we are also here, now. And if we don't act, who will?"
How climate change is affecting us and financial institutions
5. Environmental degradation and climatic change is impacting everything around
us. The Global Risks Report 2021 of the World Economic Forum (WEF) has identified
extreme weather, climate action failure and human environmental damage as the top
risks by likelihood, and climate action failure as the second most impactful risk (only
after infectious disease). The IPCC report highlighted that climate crisis is affecting
every region in the world in multiple ways. It provides new estimates of the chances of
crossing the global warming level of 1.5°C in coming decades and warns that unless
there is immediate, rapid, sustained and large-scale reduction in greenhouse gas
emissions, limiting planet warming to close to 1.5°C or even 2°C will be beyond reach.
6. A report of the Ministry of Earth Sciences, Government of India released last year
concluded that since the middle of the twentieth century, India has witnessed a rise in
average temperature, a decrease in monsoon precipitation, a rise in extreme
temperature, droughts, and sea levels, as well as increase in the intensity and
frequency of severe cyclones. There is compelling scientific evidence that human
activities have influenced these changes in the regional climate. Given the profile of
the event, it will be worthwhile to deliberate a bit further on the interlinkages between
climate related risks and financial institutions.
7. These climate trends and events have a direct bearing on the economy and
financial system including banks. Uncertainty around the severity and timing of climate
and environment related impact is a source of financial risk and may have a bearing
on the safety and soundness of individual financial institutions / entities and in turn the
stability of the overall financial system. It, therefore, becomes incumbent on financial
institutions to manage the risks and opportunities that may arise from environmental
degradation and a changing climate.
8. Climate-related financial risk refers to the risk assessment based on analysis of
the likelihoods, consequences and responses to the impact of climate change. Thus,
Climate-related financial risks may arise not just from climate change but also from
efforts to mitigate these changes. One such example is investment behaviour. Globally
many investors have already started to move away from firms which generate greater
environmental costs or engage in activities which are likely to cause environmental
harm, sometimes collectively referred as 'high-emitting sectors'. Such a trend may
result in a loss of funding or increase in financing costs for high-emitting entities which
ultimately generates viability concerns around such entities. Another important
dimension for the financial entities is the reputational impact. Reputational concerns
arise when customers financed by the financial institutions carry on business activities
which have an adverse environmental impact. These risks have already started
manifesting and are impacting the economy and financial system.
9. The good news is that the financial institutions have started recognising this threat.
In a recent international survey3, climate change topped the list of long-term risks for
banks for the first time since its inception over a decade back. More than nine in ten
(91%) of the surveyed bank chief risk officers (CROs) viewed climate change as the
top emerging risk over the next five years. The Financial Stability Report4 (FSR) of
July 2021, highlights the fact that climate change risks are ascending the hierarchy of
threats to financial stability across advanced and emerging economies alike.
Consequently, the need for an appropriate framework to identify, assess and manage
climate-related risk has become an imperative.
Climate risk is also a risk to financial firms, and it is starting to worry banks and
regulators
10. Climate change and its impact is increasingly being acknowledged as a key risk
driver for the financial system by governments, regulators and financial firms. Climate
risks can impact the financial sector through two broad channels; first - physical risks
which mean economic costs and financial losses resulting from the increasing severity
and frequency of extreme weather events and long-term climate change and second
- transition risks which arise as we try to adjust towards a low-carbon economy. It is,
therefore, important to understand these risk drivers which are likely to affect the
financial firms. Let me elaborate a bit further on them.
Physical Risk Drivers
11. Physical risk drivers are directly observable and often refer to frequent extreme
weather events which inflict direct economic costs and financial losses on financial
firms as well as longer-term but gradual shift in the climate. Such acute physical risks
arise from extreme climate change related events such as heatwaves, landslides,
floods, wildfires and storms. On the other hand, chronic physical risks are longer term
events as they arise from gradual shifts of the weather patterns such as changes in
precipitation, extreme weather variability, ocean acidification and rising sea levels and
average temperatures. Importantly, physical risk impact depends largely on
geographical locations as different regions display different climate patterns.
Transition Risk Drivers
12. Transition risks essentially reflect as compliance cost when we embark upon the
process of adjustment towards a low-carbon economy. This would include changes in
government policies, market and customer sentiments and necessity for technological
upgradation. Mandated climate-related mitigation plans could cause decrease in
financial valuation or downgrade of credit ratings for businesses which are violating
climate norms. Such plans can also cause a shift in market power from one firm to
another through introduction of subsidies to compliant firms.
Climate risk is difficult to measure and quantify
13. The broader issue which we need to be aware of and respond to is that climate
change is affecting financial firms through both - direct as well as indirect channels
and has a number of elements which present unique challenges and may, in fact,
require a de novo approach to financial risk management. The key elements of climate
change outcomes are:
• The impact is far-reaching in its breadth and magnitude, relevant to multiple
lines of business, sectors and geographies.
Given the unprecedented nature of climate change outcomes, historical data
•
and traditional backward-looking risk assessment methods are unlikely to
adequately capture future impacts.
• Climate risks may materialize over uncertain and extended time horizons which
generally extend beyond typical financial and business cycles.
We also have to be prepared for uncertainty of outcomes even where we are
•
able to foresee the nature of events.
14. It is, therefore, important to develop a better understanding of the interaction
between climate risks and business activities of financial institutions, as well as the
compounding effect such risks may have on various prudential risk categories, for
example:
Rising frequency and severity of extreme weather events can impair the value
•
of assets held by the banks' customers, or impact supply chains affecting
customers' operations, profitability and business viability affecting assessment
of credit risk.
• Shifts in investor preferences could lead to decline in valuation and increased
volatility in bank's investment books requiring change in the provision for market
risk capital.
• Increased demand for precautionary liquidity to respond to market volatility
arising from extreme weather events may induce need for higher liquidity
buffers.
• Disruption in business continuity given the impact on the financial firm's
infrastructure, systems, processes and staff.
15. The financial firms and banks are thus exposed to climate related risk through its
derivative impact on all risks which a bank or a financial firm face including,
underwriting risk, reputational risk and strategic risk. Therefore, it is important to
recognise the impact of climate risk on financial firms and plan for it.
16. Although the physical and transition risk drivers and transmission channels
through which climate risks affect financial institutions are increasingly apparent,
quantification of those risks remains a challenge for financial firms and their
supervisors. Measurement efforts have been hampered by data gaps and
methodological hurdles, many of which are unique to climate risk and contribute to
elevated uncertainty in estimates of climate-related risks. For instance, assessment of
the potential impact of climate change may require precise data on the location of a
borrower's assets and business operations, as well as information on local weather
patterns for those locations. It may also require knowledge of a counterparty's carbon
emissions and of policies in different industries and jurisdictions. Data at this level of
granularity is often unavailable or difficult to acquire, presenting challenges in
calculating the magnitude of climate-related financial risks.
Case to act early and ensure orderly transition
17. Both climate change and the transition to a carbon-neutral economy have the
potential to affect economy and by extension, general welfare of the people. Hence,
there is a clear benefit to acting early and ensuring an orderly transition. While
transition costs may be higher in the short term, they are likely to trend much lower in
the long run when compared to the costs of unrestrained climate deterioration.
18. It is thus, vital to make the financial system more resilient in the face of the
potential costs of extreme weather events. The central bank community is aware of
this and is engaged in working on this area much like the consolidated work
undertaken after the Global Financial Crisis (GFC) which had has added resilience to
the financial sector and it has come in handy during the pandemic. But more than that
supporting innovation in new technologies (clean energy and climate-related R&D) is
paramount, as is acting and investing in green infrastructure that uses better standards
and lower-carbon production processes. The financial industry has a role in and
responsibility to help develop new financial instruments to channelize savings towards
green initiatives to make them more sustainable, rewarding, and impactful. Green and
sustainable finance is, in general, the route financial sector is taking in this transition.
Green Bonds: Gaining momentum
19. At a conceptual level, "green finance" can be defined5 as financing of investments
that deliver environmental benefits in the broader context of environmentally
sustainable development. These environmental benefits include, for example,
reductions in air, water and land pollution, reductions in greenhouse gas emissions
and improved energy efficiency. Such a definition is directionally clear whilst allowing
for different technical interpretations by countries. In particular, interest in green bonds
and green finance is progressively gaining momentum as it has become a priority for
many issuers, asset managers and governments alike. Global issuance of green
bonds surpassed $250 billion in 2019 - about 3.5% of total global bond issuance ($7.15
trillion)6. Projections7 estimate that global issuance of green bond is likely to reach
$450 billion this year and that there is high possibility of issuance surpassing $1 trillion
in 2023.
Annual trillion in green bonds within reach by 2023
(Amount in US$ Billion)
1200
1000
800
600
400
200
0
2016 2017 2018 2019 2020 2021 2022 2023
forecast forecast forecast
Climate Bonds Initiative, September 2021 Report
Source:
20. Overall, developed economies contributed major part of green bond issuance
globally. Among the emerging economies, India occupies the 2nd spot (after China) in
the cumulative emerging market Green Bond Issuance, 2012-2020 (US$
million)8.
Source: Emerging Market Green Bonds Report 2020
International Initiatives on climate-related financial risk: G20 and FSB
21. A number of initiatives are under way across the international fora, central banks,
academics and private sector stakeholders to study climate-related financial risks.
Critically, climate change related topics are being given an important place in the
agenda of both the G20 and G7 for 2021, and preparations are underway for the
upcoming COP269.
22. The G20 for the first time adopted a joint final communiqué, which gives
momentum to the common mission of the G20 countries to preserve global climate
and ensure a clean and inclusive energy transition. They agreed that the crisis
unleashed by the pandemic reinforced the importance of using science as a compass
to guide the development of policies aimed at ensuring the common good. In this
sense, it was important that - for the first time - the G20 recognised the fact that the
impacts of climate change will be much lower in the context of a global temperature
rise not exceeding 1.5°C than in that of a 2°C increase, as affirmed in the "Global
Warming of 1.5°C" IPCC Special Report". On the basis of this conclusion, the
Members of the G20 decided to accelerate action to keep this 1.5°C limit on the rise
of global temperatures within reach during the critical decade of the 2020s.
23. G20 has thus made climate action a key priority and an integral part of the
recovery from the pandemic. Tackling climate change and the other challenges
needed to bring economic development onto a sustainable path requires the
involvement of the financial system and its alignment with the objectives of Agenda
2030 and the goals of the Paris Agreement10. In line with its vision, articulated around
the pillars of People, Planet and Prosperity, the G20 re-established the Sustainable
Finance Study Group (SFSG).
24. In parallel, the Financial Stability Board is working on ways to promote consistent,
high-quality climate disclosures in line with the recommendations of the Task Force
on Climate-related Financial Disclosures11. It is also continuing to work on data
requirements and gaps that are crucial for assessing the financial stability risks posed
by climate change. Concurrently, the International Financial Reporting Standards
Foundation is moving ahead with a proposal to set up an international sustainability
standards board (ISSB) to deliver the first consistent, single set of global norms for
climate-related company disclosures.
Role of central banks, BCBS and NGFS
25. The fight against climate change is certainly a task for the global economy,
society, and its institutions - including central banks. Greenhouse gas emissions do
not stop at national borders, and international trade accounts for a significant share of
global emissions. At the same time, we need to understand the roles played by all
relevant actors and how they complement each other. Therefore, coordination at the
global level would be essential. Central banks are engaged in many international fora
that have made climate change a top priority, including the Central Banks and
Supervisors Network for Greening of the Financial System (NGFS) and the Basel
Committee on Banking Supervision's Task Force on Climate-related Financial Risks
(TFCR).
26. The NGFS is a group of Central Banks and supervisors willing to share best
practices and contribute to the development of environment and climate risk
management in the financial sector. In order to learn from and contribute to the global
efforts towards enhancing the role of the financial system to manage risks and to
mobilize capital for green and low-carbon investments, the Reserve Bank of India
joined the Network for Greening the Financial System (NGFS) as a member central
bank in April 2021. The Reserve Bank expects to benefit from the membership of
NGFS by learning from member central banks and regulators and contributing to the
global efforts on green finance and the broader context of environmentally sustainable
development. It has, accordingly, begun participating in the workstreams of the NGFS
and would be making use of the NGFS platform to equip its officers with the necessary
skills and knowledge on climate-related risks.
27. The BCBS on the other hand has focused initial efforts on analytical research on
the climate topic over the past few years and published two important analytical
reports12 on climate-related risk drivers and measurement methodologies. Taken
together, the reports conclude that climate risk drivers can be captured in traditional
financial risk categories. But additional work is needed to connect climate risk drivers
to banks' exposures and to reliably estimate such risks. While a range of
methodologies is currently in use or being developed, challenges remain in the
estimation process, including data gaps, regional variations and uncertainty
associated with the long-term nature and unpredictability of climate change. The ability
to estimate and effectively mitigate climate-related financial risks will improve when
we are able to iron out these challenges or could find an alternative approach. The
TFCR is working to identify any potential gaps in the Basel Framework and develop
appropriate measures to address them.
Sustainable Finance and role of RBI in a dynamic world
28. The Reserve Bank of India's mission13 statement encompasses universal access
to financial services and a robust, dynamic and responsive financial intermediation
infrastructure and recognises the importance of active and receptive financial
intermediation. As the economy and financial system are not static, we need to
appropriately respond to the changes around us. We also need to proactively consider
new and emerging risks and opportunities while delivering monetary and financial
stability in a time consistent manner.
29. The Reserve Bank had already advised banks in 2007 to put in place an
appropriate action plan towards making a meaningful contribution to sustainable
development. Slowly and steadily, the Reserve Bank has been incentivising bank
lending towards greener industries and projects. For example, renewable energy
projects have been included under Priority Sector Lending (PSL). In 2012, RBI
included loans sanctioned by banks directly to individuals for setting up off-grid solar
and other off-grid renewable energy solutions for households and in 2015, the PSL
criteria was expanded to bank loans up to a limit of ₹ 15 crore to borrowers for
purposes like solar based power generators, biomass based power generators, wind
mills, micro-hydel plants and for non-conventional energy based public utilities viz.
street lighting systems, and remote village electrification. In 2020, the above limit for
bank loans was doubled to ₹30 crore.
30. The Reserve Bank has also tried to spread awareness on the issue of green and
sustainable finance by discussing the opportunities and challenges of green finance
through its publications and other communication. For instance, in its Report on Trend
and Progress of Banking in India 2018-19, the Reserve Bank noted the risk of a climate
change on financial assets and the need to accelerate the efforts for environment-
friendly sustainable development.
Way forward
31. We need to be conscious that addressing climate risk in the financial sector is
our joint responsibility as it may affect the resilience of financial system in long run. As
the risks and opportunities and financial impact arising from climate change vary
across jurisdictions, this poses unique considerations for emerging economy like India.
The challenge before us is to mainstream green finance and think of ways to
incorporate the environmental impact into commercial lending decisions while
simultaneously balancing the needs of credit expansion, economic growth and social
development.
32. Recently, we have set up a Sustainable Finance Group (SFG) within the
Department of Regulation in the Reserve Bank which will be spearheading RBI's
efforts and regulatory initiatives in the areas of sustainable finance and climate risk.
Some of the initiatives which we are contemplating and discussing within the Reserve
Bank are -
i) Integrating climate-related risks into financial stability monitoring.
ii) Building in-house capacity on assessment and monitoring of climate risk and
generating awareness of climate-related risks among regulated entities.
iii) Coordinating with other financial regulators to better understand the climate-related
risks to the financial system and those related to a transition to a low carbon-economy.
iv) Advising regulated entities to have a strategy to address climate change risks and
appropriate governance structures to effectively manage them from a micro-prudential
perspective.
v) Exploring forward looking tools like climate scenario analysis and stress testing for
assessing climate-related risks.
Conclusion
33. The global understanding of systemic impact of climate change on the economy
and the financial system as also its resultant impact on financial stability is evolving
and, accordingly, the responses of central banks and supervisors around the world
have also been developing. The private and the public sector need to build on our
early progress, both by recognising what we do know and urgently filling in the gaps
around what we do not.
34. I would also like to emphasize that this is not about of a particular industry, a
central bank or even a country. The impact of climate risk transcends across the
national borders and continents. Let us be aware that even the countries which are
not major contributors will also be equally impacted by these risks. We all are in it
together. All of us should also recognise that our endeavour in dealing with climate
change at this juncture cannot be approached as a marathon or as a sprint, it has to
be a well-judged middle-distance run. Every stride counts on the way.
In closing, ladies and gentlemen, I wish you a day full of learning and insightful
deliberations.
Thank you for your attention.
***