Steering climate risk: Bringing banks on board

Across the world, we see companies beginning to size up the potential effects of climate change and its risks. The banking and financial services sector is no different.

The volatile environment means, banks must certainly act on two fronts: one - look at managing their financial exposures and two - steer towards financing a green agenda. Many of the sectors that are vulnerable to climate change, such as agriculture, infrastructure, and energy, are heavily dependent on the banking sector for financing. For e.g., in India, scheduled commercial banks are the major players in supplying credit to the agriculture sector followed by rural cooperative banks. Since climate variability impacts farmers’ incomes and food security significantly, this in turn can materially impact the financial health of the banks that provide credit. Therefore, climate-risk management for banks today is indeed a necessary imperative, as it would enable banks to factor in climate related risks when assessing creditworthiness and also encourage them to tailor financial products and services that reduce credit risks and enhance agriculture resilience.

In addition to physical risks, banks also face transition risks associated with the shift to a low carbon economy. These include regulatory risks, technological risks, market changes and changing consumer preferences, which can often affect the future sustainability of investments negatively. To this effect, a draft disclosure framework recently proposed by RBI seeking to strengthen the climate resilience of Indian banks indicates an acknowledgement of this growing relevance of integrating climate considerations into financial planning processes.

The draft framework

While the RBI had suggested that REs (Regulated Entities) include climate risk in their risk appetite and in Pillar II ICAAP for impact assessment and monitoring, by way of the draft disclosure framework circular, the RBI is working towards bringing in an organised approach to how climate risk assessment is carried out by Indian banks. The framework architecture for the thematic pillars of disclosure as outlined in the RBI’s draft disclosure framework mirrors the global best practices issued by various regulatory bodies such as SEC, EBA and HKMA, as well as global disclosure frameworks such as BCBS, TCFD and ISB IFRS S2 Climate-related Disclosures wherein banks need to disclose their climate risk management practices across four pillars i.e., governance, strategy, risk management and metrics & targets.

The framework’s focus on concepts such as mispricing of assets and misallocation of capital due to climate risks, can fundamentally impact the way banks operate in India. This is a significant step towards bringing seriousness to climate risk management and underscores the urgency of addressing climate related risks for long term resilience of banks and the economy. The underlying purpose of the banking regulator is to eventually leverage the financial services sector as a way to facilitate funding activities that support a greener economy.

The guidelines provide flexibility to the REs to describe climate impacts in qualitative, quantitative, or a combination of both qualitative and quantitative terms, while encouraging the use of quantitative information where data and methodologies allow. This in turn, will provide REs the option, to adopt the disclosure stipulations in phase-wise manner, while concurrently building information maturity and disclosure conformity.

Being Future ready

To be future ready, banks, should prepare to comply with the draft framework by conducting climate risk assessments, developing climate policies and strategies, setting climate goals and targets, and communicating progress and impact. To enable all this for a long run, we are supporting our banking clients with simple, scalable, and flexible automated solutions to capture qualitative and quantitative data. While some of these data points need to be sourced externally (from suppliers, vendors and others), some can be captured from sources within the organisation. The solution will not only help deploy a harmonized data management framework in place, it will also enable the banks to seek reasonable assurance as expected by SEBI, and bring in efficiency in data collection and reporting. Today, automated platforms can help monitor progress on net zero strategies as well and help businesses re-strategize with the help of management dashboards.

Banks are also leveraging data collated from such automated platforms for conducting climate risk stress testing and impact analysis which includes an assessment of physical and transition risks.

While the draft framework is a step in the right direction towards encouraging transparency and establishing common reporting standards, a lot more needs to be done to enable data integrity along with consistency and comparability across assessments. Collaboration and knowledge sharing among banks, regulators and industry stakeholders needs to be encouraged towards developing standardized methodologies and metrics, that in turn can improve the quality and accuracy of climate risk assessments, while promoting harmonization of assessments.

This article was published by Economic Times Online on June 17, 2024