Climate risks call for green financial system

Ajay Sagar, Financial Analyst

CLIMATE risk poses a great challenge to a country’s financial system, making regulators concerned. Investors are assessing climate risks in making investment decisions. Banks are feeling the pressure to offer green deposits, investment and loan products. Some serious questions are emerging. How will the balance sheet of my pension fund look when I retire? In what manner will my life’s savings and deposits contribute towards climate change? Are current disclosures by corporates meaningful or just patchwork? Do they achieve the purpose that they are set up for? How will stakeholders understand a company’s emissions? How will carbon emissions be aggregated and reported?

Are climate risks in the financial system the domain of a central bank or the federal government? Are political institutions best placed to handle climate-related financial stability issues? Despite divergent views, there is a consensus that the financial system is exposed to systemic risks from extreme climate events requiring central banks to be prepared. Adverse climate events could potentially shift a major part of the economy on a central bank’s balance sheet. There is urgency for a long-term action plan to address transition stretching beyond the political mandate of an elected government. The need is to identify potential climate risks that can hamper a country’s financial system, infrastructure and housing investments.

Climate risks are uncertain and irreversible. With increasing frequency and severity, climate disasters have the potential to rupture economic activity, financial system, monetary policy, price stability, inflation and interest rates. Any corresponding reduction in asset values will impact banks, investors, lenders and capital markets. Payments and the clearing system could be affected. The challenge is unique. Recognising this, financial regulators worldwide have voluntarily established a network for greening the financial system (NGFS). This consensus-driven forum has a mandate to share best practices to foster a greener financial system.

Despite the recognition of climate risks and rising temperature, stakeholder response in past decades has been dominated by paying lip service, shortchanging environment and ‘greenwashing’, generating public distrust. The word ‘greenwash’ entered the dictionary in the 20th century. It means disinformation dissemination to present an environmentally responsible public image. Governance agenda worldwide needs to urgently tackle environmental insincerity. Investors need to be equipped with tools, instruments and products for making climate-smart investments. Rating agencies have now launched an ESG (environmental, social and corporate governance) evaluation initiative due to the rapidly rising demand to apply ESG lens to investing. Underwriting standards need revision to account for climate risks.

Supervisors need to promote investor awareness, research into climate-safe investments, listing of green bonds and facilitate retail green deposits. Despite a rapid growth in green bond issuance volume, market remains in its infancy lacking certification, use of proceeds and disclosure parameters. Standards developed until now lack any regulatory backing. Switzerland-based Bank for International Settlements (BIS) has advocated a case for developing a rating system linked to carbon intensity at the firm level. Regulators are working on common guidelines for issuance and certification of green bonds. EU has proposed a draft of green bond standard for voluntary compliance. The UN has mandated a CFO (chief financial officers) taskforce to provide recommendations for mainstreaming sustainable investments. International rating agencies are gearing up to embed climate risk in assigning sovereign risk ratings. A business-as-usual approach, relying on implicit or explicit guarantees to depositors, will not suffice. Globally, a few regulators have commenced work on linking bank deposit insurance to greening parameters. Central banks are examining options to tweak risk weightage on securities and reserves in favour of green investing.

A recent IMF study highlighted that climate change physical risk does not appear to be reflected in global equity valuations. Current asset values may be missing on climate risks. Seeing benefits, the private sector is playing a pivotal role in developing climate resilience. India’s large conglomerate Reliance recently gave a timeline to go net carbon-neutral by 2035, much earlier than BP Shell’s timeline of 2050. HDFC bank declared its intent to go carbon-neutral by 2032. Benefits come in the form of brand value creation, skill enhancement and retention, boosting employee morale, access to capital markets and increased market capitalisation. Company boards could become climate-savvy by sensitising themselves on climate governance to fulfil their oversight and directional role. Recently, New York’s insurance regulator mandated insurers to beef up governance by making a board committee or a senior functionary responsible to address potential climate risks in solvency and risk assessments.

Mere AAA rating of central bank reserves is not enough. Financial safety of reserves is incomplete unless blended with safety from climate risks. Central banks now need to invest in climate-resilient AAA reserves that provide the highest degree of safety and are liquid. Charity begins at home and Ireland’s central bank took the first step by disclosing its investment in green bonds. This initiative will help reflect true asset valuations by capturing financial risks related to climate risks. Insurers, private equity, pension and hedge funds are now demanding climate-related financial disclosures.

Earlier, 100 institutional investors holding $1.8 trillion in assets asked top 60 banks for robust climate-risk disclosures. Quality disclosures could convincingly move investors’ free will towards green investing. Central banks are examining equating or giving climate-related data the same status as accounting disclosure. There is also a move to consider pricing carbon risk in the context of syndicated bank loans. Carbon intensity data can help capture the severity of financial impact of tightening carbon emission policies.

It’s essential to better assess and address climate risk concentrations as financial systems may be underprepared. Monetary policy affects stakeholder behaviour and economic activity. It now needs to reflect a green footprint away from fossil fuels. Is the RBI ready for a green monetary policy? India’s financial regulators will soon need to start making public their position on climate-related financial stability risks. Postponement of a green monetary policy is not an option any more. The IMF has started engaging countries to assess stability risk arising from climate risks. NITI Aayog could help coordinate the initiative. Left unchecked, a transition risk can cause ripples in the financial system and market failures. India needs to be at the forefront of greening the financial sector agenda.