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RBI's Framework for Climate-related Financial Risks

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March 13, 2024

Why in news?                        

Recently Reserve Bank of India (RBI) has proposed a Disclosure framework on Climate-related Financial Risks, 2024 to address the financial risks associated with climate change.

Why there is a need of disclosure framework by RBI?

  • Credit risk- If customers’ asset values decline due to climate-related factors such as  damage from extreme weather events), banks could face credit risk this may impact borrowers who struggle to repay debt, leading to potential losses for lenders.
  • Supply chain impact-Disruptions in supply chains due to climate events can affect operations, profitability, and viability which in turn impacts borrowers’ ability to service debt.
  • Liquidity demand- Consumers may need funds to cope with extreme weather events or other climate-related challenges which leads to liquidity demand.
  • Asset liquidation-Consumers may perceive difficulties in liquidating assets affected by climate events, affecting their capacity to raise funds.
  • Claims exposure- Banks face the risk of not meeting exposure to claims such as insurance claims from customers seeking to recover climate-related losses, it is particularly risky in vulnerable sectors such as agriculture, tourism etc.,
  • Market risks- A shift in investor preferences toward sustainable investments can impact financial markets.
  • Adverse climate effects on economic activity can lead to market risks.
  • Vulnerable NBFCs- Non-Banking Financial Corporations extend significant credit to sectors like power and automobiles (both with high carbon footprints) and MSMEs that rely on conventional fuel.
  • The interconnectedness of these sectors raises concerns about potential “large-scale default” leading to “macro financial instability”.

What are the key highlights of disclosure framework by RBI?

  • Climate related financial risk- It means the potential risks that may arise from climate change or from efforts to mitigate climate change, their related impacts and economic and financial consequences.
  • Purpose- The regulated entities must disclose information about their climate-related financial risks and opportunities for the users of financial statements.
  • Disclosure of information-
    • Identified climate-related risks and opportunities over short, medium and long term.
    • The impact of climate-related risks and opportunities on their businesses, strategy and financial planning.
    • The resilience of the RE's strategy taking into consideration the different climate scenarios.
  • Applicability- The guidelines shall be applicable to the following entities, collectively referred to as Regulated Entities (REs)
    • All Scheduled Commercial Banks (excluding Local Area Banks, Payments Banks and Regional Rural Banks)
    •  All Tier-IV Primary (Urban) Co-operative Banks (UCBs)
    • All All-India Financial Institutions (viz. EXIM Bank, NABARD, NaBFID, NHB and SIDBI)
    • All Top and Upper Layer Non-Banking Financial Companies (NBFCs).

Climate

  • Governance-It should detail the governance processes, controls and procedures used by the RE to identify, assess, manage, mitigate, monitor and oversee climate-related financial risks and opportunities.
  • Strategy-It should detail the RE’s strategy for managing climate-related financial risks and opportunities.
  • Risk management- It should detail the RE’s processes to identify, assess, prioritize and monitor climate-related financial risks and opportunities, including whether and how those processes are integrated into and inform the RE’s overall risk management process.

Risk categorization

Physical risks

Transitional risks

  • Direct consequences of extreme weather events such as floods, storms, or wildfires can lead to economic costs and financial losses.
  • Long-term shifts in climate patterns, such as rising sea levels or extreme weather variability, can affect the value of assets, particularly immovable property serving as collateral for loans.
  • Damage to properties or data centers due to severe weather events can disrupt banking operations, impacting services to customers.
  • Degradation of soil quality or marine ecology can indirectly affect economic activities and sectors.
  • Risks associated with the transition to a low-carbon economy, including policy changes favouring clean energy or technological innovations.
  • Downgrades in credit ratings or financial valuation due to climate mitigation policies.
  • Increased costs or operational overhauls to comply with new regulations or adopt sustainable practices.
  • Depreciation of assets dependent on older, high-carbon technologies.
  • Shifts in public sentiment towards climate-friendly investments, impacting demand for certain financial products.
  • Metrics and targets- It should detail the RE’s performance in relation to its climate-related financial risks and opportunities, including progress towards any climate-related targets it has set, and any targets it is required to meet by statute or regulation.

Scope GHG emission

 

References

  1. The Hindu- RBI’s proposal for disclosure framework
  2. RBI- Draft disclosure framework on climate related financial risks
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