Climate change is one of the defining challenges of our times. It is a classic example of a ‘collective action problem’ – one requiring collaborative action between individuals, groups and nations, but where such coordinated action is difficult on account of misaligned incentives. Climate change is likely to result in physical and transition risks that could have implications on stability of the overall financial system as well as the physical safety and financial soundness of banks, financial institutions. Given the potential implications of climate change on monetary policy as well as financial stability, addressing it should be part of the mandate of central banks and financial regulators.
Banks and financial institutions, therefore, have a critical part to play in managing climate risks – by directing credit towards sustainable industries and away from brown ones. One effective approach is to encourage green deposits and investments in green projects, as laid down by the RBI in its recently-released regulatory framework, which we have analysed in our previous post. The financial system itself is not insulated from the climate risks, which impacts financial stability and liquidity. Therefore, it is essential to mitigate these risks to build resilience and ensure stability of the financial system.
International and multilateral bodies have been alive to this risk. The International Monetary Fund (“IMF”) has taken steps to include climate risk in their financial assessment programs (“FSAP”). At the Paris ‘One Planet Summit’ in December 2017, the Network for Greening the Financial System (NGFS), a group of central banks and financial supervisors focussed on scaling up of green finance, was established. Since then, the membership of NGFS has grown dramatically to 125 members and 19 observers, including the Reserve Bank of India (“RBI”)[1]. The Bank of International Settlements (“BIS“) also issued principles in June 2022 (“Principles”), for the effective management and supervision of climate-related financial risks.
Subsequently, in July 2022, the RBI released a discussion paper on ‘Climate Risk and Sustainable Finance’ (“Discussion Paper”).[2] Further to the feedback received from the industry and stakeholders, apart from green deposits, the RBI identified two priority areas to issue guidelines[3] for regulated entities (“REs”) – disclosures and stress testing/scenario analysis. We examine the international and comparative regulations on these two subjects and explore what RBI’s interventions for these may look like.
Disclosures
Climate-related disclosures are relevant for all stakeholders, including the RBI, government, investors customers and even the REs. Such disclosures help informed decision-making, analysis of past actions and brainstorming of improvement strategies, including shaping future regulation. In the Discussion Paper, REs have been encouraged to start aligning their existing financial disclosures with Task Force on Climate-related Financial Disclosures (“TCFD”). In 2015, the Financial Stability Board at the request of G20 leaders, established the industry-led TCFD to allow markets to better assess, price and manage climate-related financial risks. In 2017, the TCFD developed a framework to help publicly listed companies and other organisations to more effectively disclose climate-related risks and opportunities through their existing reporting processes.[4] The TCFD recommendations have gone through extensive consultations and is one of the most prominent and widely recognised standards across jurisdictions. They are designed to solicit forward-looking information that can be included in mainstream financial filings as well as information relevant for decision making. The recommendations are structured around four thematic areas that represent core elements of how organisations operate: governance, strategy, risk management, metrics & targets.
Meanwhile, the International Sustainability Standards Board (“ISSB”) is currently in the process of issuing IFRS Sustainability Disclosure Standards around the end of second quarter of 2023[5], which will replace TCFD in some countries. Most jurisdictions like UK, Singapore and Australia are working towards adopting ISSB disclosure standards over time, whereas European Union and the United States are working on their own mandatory climate disclosure requirements for companies[6].
This demonstrates an inconsistency in international taxonomy and the growing need for harmonised international standards. As India holds the Presidency of the G20 this year, it could use this opportunity to forge a consensus on international taxonomy and alignment between TCFD and ISSB, while also harmonising expectations of the IMF for FSAPs. Further, it could raise the issue of proportionate application of the TCFD to emerging economies like India, and to reframe the guidelines to gain awareness of and allow the flow of sustainable finance from developed to developing countries.
Domestically, while the RBI has rightly considered and recommended TCFD as a desirable framework to be relied upon by the REs for disclosures, it would also be important to consider the ISSB standards, which may replace TCFD for certain systemically important industries.
In March 2023, the Bank of England (BOE), known for its pioneering efforts in integrating sustainability into its mandate, released a report on climate-related risks[7]. The report, inter alia highlights that the firms are likely to face challenges in measuring climate risks and determining related capital needs due to gaps in disclosure by counterparties across the economy, the associated paucity of data, and the absence of established best practices. In such cases, BOE has recommended that firms should use reasonable proxies, assumptions, and judgment to work around these issues and not leave known material risks uncapitalised while acknowledging that initiatives are underway to improve climate disclosures, including standards being developed by the ISSB to set a comprehensive global baseline. This approach is particularly relevant for the Indian financial sector given India’s vulnerabilities to (and opportunities from) climate change and its nascency in the financial sector.
Some listed banks like the State Bank of India and HDFC Bank already have an ESG framework[8] in place on account of a range of regulatory and other factors including, compliance required pursuant to SEBI BRSR[9] and or on account of having raised green bonds or debt in the international market or in voluntary recognition of the risks and opportunities presented by climate change. However, irrespective of this fragmented approach, relevant entities might have to additionally comply with the RBI guidelines, which would be incremental to BRSR as there is a need for consistent, comparable, uniform and globally aligned disclosures in relation to climate-related financial risks.
Given that the green transition will come at a cost, inter-regulatory co-ordination will be required to avoid creating a dual compliance regime for REs. It will be critical for REs to be well prepared for this transition, which might soon become a mandatory regulatory compliance.
Stress testing and scenario analysis
The requirement of past data and the unpredictable nature of climate change makes estimation of climate events and their financial impact a challenging endeavour. In his recent speech on green finance[10], the RBI Deputy Governor highlighted the need to consider ‘long-time horizon’ when modelling climate-related risks. As the climate events may often span across decades, if not centuries, it may make the data collection and future projections quite difficult and the outcomes more uncertain. Therefore, building a toolkit to help manage and mitigate them is unprecedented.
Stress testing and scenario analysis are key components of such a toolkit, which seek to anticipate possible losses that might occur if an identified economic downturn or risk events crystallise. Stress testing typically refers to shifting the values of individual parameters that affect the financial position of a firm and determining the effect on the firm’s financial position. Whereas, scenario analysis refers to a wider range of parameters being varied at the same time. Scenario analysis often examines the impact of adverse events on the firm’s financial position.[11]
The BIS in its Principles stated that “Supervisors should consider using climate-related risk scenario analysis to identify relevant risk factors, size portfolio exposures, identify data gaps and inform the adequacy of risk management approaches.” Further, they may consider the use of climate-related stress testing to evaluate a firm’s financial position under “severe but plausible scenarios”.
In March 2022, the ISSB published Exposure Drafts: ‘IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information’[12] and ‘IFRS S2 Climate-related Disclosures’[13], which includes requirements to disclose, inter alia, results of scenario analysis (or alternative approaches such as qualitative analysis, sensitivity analysis and stress tests) with an assessment of associated implications of the resilience of the company’s strategy and business model over different time horizons. At the global level, the ISSB has also unanimously confirmed that companies will be required to use climate-related scenario analysis to report on climate resilience and to identify climate-related risks and opportunities to support their disclosures.[14]
These forward-looking techniques, i.e. stress test and scenario analysis are not novel and have been in use for a while. The RBI has been using these tools to assess stress levels in relation to non-performing assets, capital requirements, etc., in the financial sector[15]. The RBI guidelines on stress testing (“Stress Testing Guidelines”) for scheduled commercial banks, which were released in response to the global financial crisis in 2008 and updated in 2013, can serve as an effective roadmap for REs in managing climate risks[16]. The requirement of appropriate and flexible infrastructure, design, reverse stress testing, responsibility of board and senior management, frequency of stress testing, etc., are some of the relevant themes that the RBI has already provided for and these may be contextualised for climate specific risks.
It is indeed time for the RBI and REs to incorporate these tools in the context of climate finance. The integration of these can be achieved through regular monitoring exercises and overall financial risk assessment, both at a macro-prudential level for the financial sector by the RBI as well as by imposing micro-prudential regulations on REs themselves. This will also require developing appropriate technological solutions, developing policy design, capacity building and sensitisation amongst REs.
The RBI can spearhead this transition by drawing on best practices from other jurisdictions like the United Kingdom, Singapore, and Australia, which are at advanced stage of using climate scenario analysis and stress testing. For instance, the UK Supervisory Statement suggests that an entity could use the results of stress testing and scenario analysis to not only assess its capital needs, but also to decide if measures should be put in place to minimise the adverse effect on the entity if the risks covered by the stress test or scenario analysis actually materialise. Such measures might be a contingency plan or more concrete risk mitigation steps[17].
Going forward, the RBI may consider: (a) extending the applicability of the Stress Testing Guidelines to REs apart from scheduled banks; (b) integrating climate-related financial risk in the guidelines in addition to risks related to NPAs, economic downturn / countercyclical risks as well as physical and transition risks.
A significant fine tuning is required by the regulator to integrate climate risks into regulatory and prudential framework for REs. The legal mandate for the financial sector regulator to develop a framework for climate finance should also be examined thoroughly to ensure it stands the test of judicial scrutiny. Further, REs must also be prepared to invest in capacity building, improving governance, risk management and technology solutions to effectively implement the regulatory mandate. The RBI can play a crucial role in shaping the financial sector’s response to climate risks through appropriate guidance, regulations and policy-making. Lastly, the REs will need to proactively develop and implement comprehensive frameworks to understand and assess the potential impact of climate-related financial risks in their business strategies and in structuring their products and services – not just on account of regulatory directives but commercial and existential imperatives.
[1] Origin and Purpose, NGFS, available at: https://www.ngfs.net/en/about-us/governance/origin-and-purpose
[2] Discussion Paper on Climate Risk and Sustainable Finance, Department of Regulation, RBI, available at: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/CLIMATERISK46CEE62999A4424BB731066765009961.PDF
[3] Statement on Developmental and Regulatory Policies issued on February 8, 2023, available at: Reserve Bank of India – Press Releases (rbi.org.in)
[4] Recommendations of the Task Force on Climate-related Financial Disclosures, June 2017, available at: FINAL-2017-TCFD-Report.pdf (bbhub.io)
[5]General Sustainability-related Disclosures, IFRS, available at:https://www.ifrs.org/projects/work-plan/general-sustainability-related-disclosures/
[6]Urgent progress needed on company climate disclosures, G20 task force says, Simon Jessop and Huw Jones, October 2022, available at: https://www.reuters.com/business/sustainable-business/urgent-progress-needed-company-climate-disclosures-g20-task-force-says-2022-10-13/
[7] Bank of England report on climate-related risks and the regulatory capital frameworks, March 2023, available at: Bank of England report on climate-related risks and the regulatory capital frameworks | Bank of England
[8]Environmental Social & Governance (ESG) Policy Framework, HDFC Bank, 2020, available at: https://www.hdfcbank.com/content/api/contentstream-id/723fb80a-2dde-42a3-9793-7ae1be57c87f/f0ac1d94-7b3f-4b7a-ad10-d84cd154eaed?
[9]Business Responsibility and Sustainability Report, HDFC Bank Limited, 2022, available at: https://archives.nseindia.com/corporate/BR_HDFCBANK_2021_2022_20220800047.pdf
[10] Challenges and Opportunities in Scaling up Green Finance, Shri M. Rajeshwar Rao, Deputy Governor, Reserve Bank of India, December 2022, available at https://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/BSBFSISUMMITF9F9354E0E074B9DAC7DC5D38AA78559.PDF
[11] Supervisory Statement | SS31/15, Bank of England, Prudential Regulation Authority, December 2021, available at: Supervisory Statement (SS31/15), PRA
[12] Exposure Draft- IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information, March 2022, available at: https://www.ifrs.org/content/dam/ifrs/project/general-sustainability-related-disclosures/exposure-draft-ifrs-s1-general-requirements-for-disclosure-of-sustainability-related-financial-information.pdf
[13]Exposure Draft – IFRS S2 Climate-related Disclosures, March 2022, available at: https://www.ifrs.org/content/dam/ifrs/project/climate-related-disclosures/issb-exposure-draft-2022-2-climate-related-disclosures.pdf
[14]ISSB confirms requirement to use climate-related scenario analysis, November 2022, available at: https://www.ifrs.org/news-and-events/news/2022/11/issb-confirms-requirement-use-climate-related-scenario-analysis/
[15]RBI releases the Financial Stability Report, December 2022, available at: https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=54955
[16]RBI Guidelines on Stress Testing, December 2013, available at: https://rbidocs.rbi.org.in/rdocs/notification/PDFs/FC021212ST.pdf
[17] Supervisory Statement | SS31/15, Bank of England, Prudential Regulation Authority, December 2021, available at: Supervisory Statement (SS31/15), PRA
