Greening the Financial System

Introduction

One Plant Summit, that was held in Paris in December 2017 announced the formation of a Network for Greening the Financial System (NGFS). The purpose is to help strengthen the global response required to meet the goals of the Paris Agreement and enhance the role of the financial system to manage climate-related and environmental risks. The RBI is the latest member of the Network which consists of 89 central banks and supervisors with 13 observers as of now.

The idea behind the formation of such a system is that the financial system is at risk by the impact of climate change on businesses indirectly. In addition to financial risks, Banks normally face climate-related and environmental risks that also lead to risks to the Banks when its borrowers are realigning their business to transit to more environmentally friendly business strategies. Adverse changes in climatic conditions and degradation of environmental imbalances will lead to affect economic activity and thus in turn the financial system. Two main risks have been identified in this regard.

Physical Risk

Economic costs and financial losses resulting from the increasing severity and frequency of extreme climate change-related weather events (or extreme weather events) such as heatwaves, landslides, floods, wildfires and storms (i.e acute physical risks); longer-term gradual shifts of the climate such as changes in precipitation, extreme weather variability, ocean acidification, and rising sea levels and average temperatures (i.e chronic physical risks or chronic risks); and indirect effects of climate change such as loss of ecosystem services (eg. desertification, water shortage, degradation of soil quality or marine ecology). Physical risk drivers are the changes in weather and climate mentioned above that lead to physical risks and impacts on economies and banks (eg. a flood).

They can be categorized as either acute - if they arise from climate and weather-related events - or chronic - if they arise from progressive shifts in climate and weather patterns. Physical risks include the economic costs and financial losses resulting from the increasing severity.

Transition Risk 

The risks related to the process of adjustment towards a low-carbon economy. These drivers represent climate-related changes that could generate, increase or reduce transition risks. They include changes in public sector (generally government) policies, legislation and regulation, changes in technology and changes in market and customer sentiment, each of which has the potential to generate, accelerate, slow or disrupt the transition towards a low-carbon economy.

The governments may change their policy guidelines to relieve the environmental risks. Additional costs may be incurred by the industry to meet these requirements. For example, as per the new norms on emission standards, the Indian Automobile Industry is set to make the transition from BS4 to the stricter BS6 emission norms from April 1, 2020. The process involves upgrading the current technology used in vehicles, be it cars, two-wheelers, trucks, or buses. It also means the cost of manufacturing is set to grow; therefore, the price of the final product is expected to rise substantially. It will impact the entire automobile industry, its supply chain, and the cash flows. Transition risks can occur when moving towards a less polluting, greener economy. Such transitions could mean that some sectors of the economy face big shifts in asset values or higher costs of doing business. It may cost the industry heavily while transiting to the greener format of the business. Transition costs will have bearing on the input costs and will affect the profitability of the company.

The table below summaries the potential effects in each risk category.

 (Source: Basel document dated 20.4.2021)

Sectors impacted

The important sectors like Agriculture and agriculture-based businesses, forestry, fisheries, human health, energy, mining, transport, infrastructure, tourism and business connected with these are the most affected by climate change. For example, the recent health-related issues with the onslaught of COVID had impacted many sectors such as automobile, consumer goods etc. Sectors like energy, transport, manufacturing, construction may be impacted because of the above environmental issues and thus the whole financial sector. The financial sector, in general, includes Banking, Insurance and investment companies and even real estate firms.

The impact of environmental change may not be uniform across the world. Especially in our country, certain parts of the country are affected by floods while others are by drought.

When banks consider financing to sectors that are more vulnerable to climatic changes thus resulting in credit risk need to have a forward-looking approach to mitigate the impact in long run.

The European Central Bank, Banking Supervision has given certain guidelines in this regard.

Credit Risk Management

(1) The financial Institutions to consider climate-related and environmental risks at all relevant stages of the credit-granting process and to monitor the risks in their portfolios.

(2) In order to assess the above, the financial institutions consider the borrower's management policies in this regard. For instance, overexploitation of natural resources, such as water, in certain areas might lead to limitations on their use, which can lead in turn to disruptions to production and losses to institutions' counterparties.

(3) The financial institutions need to provide certain weightage in their credit rating modules while rating the borrowers on climate-related and environmental risks.

(4) Institutions are expected to consider climate-related and environmental risks in their collateral valuations.

(5) Institutions to monitor and manage credit risks in their portfolios, through sectoral/geographic/single-name concentration analysis, including credit risk concentrations stemming from climate-related and environmental risks, and using exposure limits or deleveraging strategies

(6) Institutions' loan pricing frameworks to reflect their credit risk appetite and business strategy about climate-related and environmental risks

Operational Risk management

(1) Institutions to consider how climate-related and environmental events could harm business continuity and the extent to which the nature of their activities could increase reputational and/or liability risks.

(2) Institutions to assess the impact of physical risks on their operations in general, including the ability to quickly recover their capacity to continue providing services.

(3) Institutions to evaluate the extent to which the nature of the activities in which they are involved increases the risk of a negative financial impact arising from future reputational damage, liability and/or litigation

Market risk management

(1) Institutions to monitor on an ongoing basis the effect of climate-related and environmental factors on their current market risk positions and future investments, and to develop stress tests that incorporate climate-related and environmental risks.

Liquidity risk management

(1) Institutions to assess whether material climate-related and environmental risks could cause net cash outflows or depletion of liquidity buffers and if so, incorporate these factors into their liquidity risk management and liquidity buffer calibration.

The Network for Greening the Financial System in its Guide for Supervisors published in May 2020 has laid down the following action points for Supervisory bank.

(1) Recommendation 1 - Supervisors are recommended to determine how climate-related and environmental risks transmit to the economies and financial sectors in their jurisdictions and identify how these risks are likely to be material for the supervised entities.

(2) Recommendation 2 - Develop a clear strategy, establish an internal organization, and allocate adequate resources to address climate-related and environmental risks.

(3) Recommendation 3 - Identify the exposures of supervised entities that are vulnerable to climate-related and environmental risks and assess the potential losses should these risks materialize.

(4) Recommendation 4 - Set supervisory expectations to create transparency for financial institutions in relation to the supervisors' understanding of a prudent approach to climate-related and environmental risks

(5) Recommendation 5 - Ensure adequate management of climate-related and environmental risks by financial institutions and take mitigating action where appropriate.

Since the RBI also joined the Network to take advantage of global standards being set to mitigate the impact of transition costs to a greener climate, we can expect some directions may be announced to the Banks.

Conclusion

Basel Committee on Banking Supervision is also working on the issue and mapping them with the various components of risk already mentioned in Basel III guidelines.

Some measures may include, revisiting the credit rating modules by the Banks to incorporate whether weightage has been given if the borrower is being impacted by environmental hazards. Banks may need to support the borrower by funding the transition costs. As loan losses are likely to increase, additional provisioning norms may be stipulated for those borrowers who are likely to spend on transitions. The risk-weighted assets conversion factors may be increased in those accounts where the impact is likely to be relevant to the profitability of the units.

The Reserve Bank of India (RBI) has joined the Central Banks and Supervisors Network for Greening the Financial System (NGFS) as a Member on April 23, 2021. The subject matter is attracting the attention of all global banks and we can expect viable options and guidelines to be issued by the regulator.

Sources:

• Network for Greening the Financial System - Technical Document - Guide for Supervisors - dated May 2020
• European Central Bank, Banking Supervision Guide on Climate-related and environmental risks - dated November 2020.
• Basel Committee report dated April 2021 on Climate-related risk drivers and their transmission channels