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ESG Implementation in India: Role of RBI in Driving Sustainable Finance

August 21, 2024

Despite the challenges of inadequate climate financing, India has been at the forefront of sustainable development. The country has been ambitious in its climate actions, taking bold policy steps towards its Net Zero goals by 2070. To know more visit Link.

Regulators have  actively participated in achieving India’s targets. In a previous Blog we explained  SEBI’s role in the implementation of ESG in India which can accessed at Link.

The threat of rising temperatures causing economic havoc is highlighted by NGFS (Network for Greening the Financial System), a global body focusing on green change in the financial system. In response, the Reserve Bank of India (RBI) has taken several initiatives to implement ESG policies within financial institutions.

 

Problems Caused in  India’s Financial Sector by Climate Change

  • Uncertainty in investments in certain sectors: Investments by banks in sectors such as construction and energy will face challenges as these industries are highly impacted with the adverse effects of climate change, leading to a notable decline in asset quality.
  • Banks may hold back capital: Banks might hesitate to invest in certain sectors which are highly susceptible to potential losses caused by climate change.
  • Increase in bad loans and defaults: Sectors like agriculture, which are vulnerable to adverse weather conditions such as monsoons, may see a rise in loan defaults as farmers and agriculturalists struggle to repay their debts.
  • Large capital outflow potentially stalling ongoing projects: Investors in green projects may withdraw funding before project completion due to anticipated delays, resulting in incomplete projects and significant setbacks for India’s green initiatives.
  • Stress on financial institutions: The economic instability brought about by climate change creates additional stress on financial institutions, making them more cautious about investments and requiring them to allocate resources to manage these challenges.

 

RBI’s Role in ESG Implementation

I. In the Discussion paper on Climate Risk and Sustainable Finance- RBI asserts that Climate change is increasingly recognized globally as a significant financial risk for financial institutions as well as posing a threat to the safety, soundness, and resilience of individual Regulated Entities (REs), which in turn impacts the stability of the entire financial system. Therefore, it is essential for REs to proactively manage the risks and opportunities arising from climate change and environmental degradation. Financial Stability Board (FSB) has acknowledged that climate-related financial risks could jeopardize global financial stability and has developed a roadmap to ensure these risks are adequately reflected in all financial decisions. This roadmap promotes international coordination by unifying the efforts of international organizations and national authorities across various initiatives. FSB’s focus is on four key pillars: disclosures, data, vulnerability analysis, and regulatory and supervisory approaches. The paper offers several recommendations:

 

a) Understanding Risks:

  • Credit Risk: The increasing frequency and severity of extreme weather events can devalue assets held by banks’ customers, disrupt supply chains, affect customers’ operations and profitability.
  • Market Risk: Banks may experience declines in valuation and increased investment volatility due to shifts in investor preferences or adverse climate-induced effects on underlying economic activities.
  • Liquidity Risk: There may be increased demand for liquidity to respond to extreme weather events or challenges in liquidating assets due to their negative impact.

 

b) Board-Level Committees:

  • REs should establish a committee or sub-committee at the Board level, including experts in sustainability and risk management, responsible for:
  • Guiding climate-related policy, strategy, objective-setting, and performance monitoring.
  • Mandating processes to identify and manage climate-related and environmental risks and opportunities.
  • Ensuring the timely and regular updating of internal risk reports and the effectiveness of mitigation measures.
  • Monitoring progress on relevant goals and targets.
  • Guiding external disclosures.

 

c) Assigning Responsibilities: REs should assign clear responsibilities for managing climate-related financial risks to appropriate committees. Material climate-related financial risks should be integrated into the RE’s business strategy and risk management framework. The Board and Senior Management should have a sufficient understanding of these risks, and steps should be taken for capacity building and upskilling through internal workshops, training, or external collaboration.

 

d) Risk Framework: REs should incorporate climate-related risk indicators into their risk appetite framework. These indicators should include objective and measurable metrics, with limits cascading down to the sector and portfolio levels. Examples of such indicators include:

  • Concentration in CO2/GHG-intensive assets.
  • Carbon emission footprint of the portfolio.
  • Climate-risk assessments as part of the due diligence process, including physical, transitional, and reputational risks, resulting in a climate-risk rating for customers with material exposure to such risks. High-risk ratings should be periodically monitored.

 

e) Climate-Related Policy: REs should develop a climate-related policy considering material physical and transition risks, with clear definitions and assignment of responsibilities and reporting lines across the three lines of defense:

  • First Line: Should identify potential climate-related financial risks with sufficient awareness and understanding.
  • Second Line: Should independently assess and monitor climate-related risks, ensuring compliance with applicable rules and regulations, and report material risks to the Board.
  • Third Line: Should conduct regular reviews of the overall internal control framework and systems, including the quality of underlying data.

 

II. Draft Guidelines on Climate-Related Financial Disclosures- Based on the above suggestions RBI has come up with draft guidelines on the disclosure framework for climate-related financial risks for regulated entities (REs) on 28th February, 2024. These guidelines applies to:-

a) Scheduled Commercial & Co-operative Banks

b) Top and upper layer NBFCs

c) All Financial Institutions

In the draft they have defined “climate related financial risk” in Para 6(a) as “potential risks that may arise from climate change or from efforts to mitigate climate change, their related impacts and economic and financial consequences.”

In the draft they have come up with 4 thematic pillars of disclosures that REs are required to make:-

  • Governance: REs to identify, assess, manage, mitigate, monitor and oversee climate-related financial risks and opportunities. The REs shall inter alia disclose:

a) The Board’s oversight of climate-related risks and opportunities;

b) Senior Management’s role is to assess & manage climate-related risks and opportunities.

  • Strategy: It should detail the RE’s strategy for managing climate-related financial risks and opportunities. The REs shall inter alia disclose as part of RE’s financial results/ statements on their website:

a) The identified climate-related risks and opportunities over short, medium and long term;

b) The impact of climate-related risks and opportunities on the RE’s businesses, strategy and financial planning;

c) The resilience of the RE’s strategy taking into consideration the different climate scenarios.

  • 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. The REs shall inter alia disclose:

a) The processes and related policies to identify, assess, prioritize and monitor climate-related financial risks;

b) The processes used for managing climate-related risks;

c) The extent to which, and how, the processes for identifying, assessing, prioritizing and monitoring climate-related financial risks and opportunities are integrated into and inform the overall risk management.

  • Metrics and Targets: The disclosures on metrics and targets 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. The REs shall inter alia disclose:

a) The metrics used to assess the climate-related financial risks and opportunities in line with its strategy and risk management process;

b) Scope 1, Scope 2 and Scope 3 greenhouse gas (GHG) emissions and the related risks;

c) The targets used to manage climate-related risks and opportunities and performance against targets.

REs were requested to provide their comments and feedback on these guidelines by the end of April.

 

III. Framework on Green Deposits- On April 11, 2023, the RBI introduced a framework for the acceptance of green deposits, which became effective on June 1, 2023. This framework applies to:

  • Scheduled Commercial Banks
  • Deposit-taking NBFCs, including HFCs

The aim of this framework is to encourage regulated entities (REs) to offer green deposits to customers, safeguard depositors’ interests, assist customers in achieving their sustainability goals, address concerns about greenwashing, and enhance the flow of credit to green activities/projects. In this framework, “green deposit” is defined as an interest-bearing deposit received by REs for a fixed period, with the proceeds allocated towards green finance. Similarly, “Green finance” refers to lending to and/or investing in activities/projects that meet the criteria outlined in paragraph 7 of the guidelines, contributing to climate risk mitigation, climate adaptation and resilience, and other climate-related or environmental objectives, such as biodiversity management and nature-based solutions.

REs are required to allocate proceeds from green deposits towards the following green activities/projects that promote energy efficiency, reduce carbon emissions and greenhouse gases, enhance climate resilience and adaptation, and improve natural ecosystems and biodiversity:

  • Renewable energy
  • Energy efficiency
  • Clean transportation
  • Climate change adaptation
  • Sustainable water and waste management
  • Green buildings

Not surprisingly,  the framework excludes the following:-

  • Projects involving the extraction, production, and distribution of fossil fuels, including improvements and upgrades, or where the core energy source is fossil-fuel-based.
  • Nuclear power generation.
  • Direct waste incineration.
  • Alcohol, weapons, tobacco, gaming, or palm oil industries.
  • Renewable energy projects generating energy from biomass using feedstock originating from protected areas.
  • Landfill projects.
  • Hydropower plants larger than 25 MW.
  • Additionally, REs must submit a report to their Board of Directors within three months after the end of the financial year. This report must include:
  • The amount raised through green deposits during the previous financial year.
  • A list of green activities/projects to which proceeds have been allocated, along with brief descriptions of the projects.
  • The amounts allocated to the eligible green activities/projects.
  • Copies of the Third-Party Verification/Assurance Report and the Impact Assessment Report.

 

IV. Membership in the Network for Greening the Financial System (NGFS)- RBI joined the Central Banks and Supervisors Network for Greening the Financial System (NGFS) in April 2021. NGFS is a group of central banks and supervisors sharing best practices and contributing to the development of climate risk management in the financial sector.

 

V. Survey on Climate Risk and Sustainable Finance- In January 2022, RBI’s Sustainable Finance Group (SFG) conducted a survey to assess climate risk and sustainable finance among leading scheduled commercial banks. Key findings include:

  • Risk Management: Most banks recognize climate-related financial risks as a material threat, with physical and transition risks being the primary concerns.
  • Transition to Low-Carbon Exposure: Many banks plan to reduce their exposure to high-carbon emitting businesses.
  • Green Lending and Investment: Several banks have mobilized new capital for green lending, set targets for sustainable finance, and launched green deposit products.

 

VI. Report on Currency and Finance for FY 2022-23- RBI’s report for FY 2022-23 focused on ‘Towards a Greener Cleaner India’. It outlines a roadmap for transitioning towards a sustainable economy, emphasizing the need for reducing carbon emissions and conserving natural resources. The report calls for financial institutions to incorporate ESG principles into their decision-making processes and assess the long-term sustainability of businesses and investments.

 

Conclusion

RBI’s efforts in promoting ESG have significant implications for the Indian financial sector and the broader economy. By integrating ESG principles, RBI aims to achieve sustainable economic growth while mitigating risks associated with environmental degradation, social inequalities, and governance failures.

As the world increasingly focuses on sustainability, the RBI’s proactive approach positions India as a leader in responsible finance. The continued emphasis on ESG will not only attract sustainable investments but also drive innovation and create long-term value for all stakeholders. Through guidelines, sustainable finance initiatives, capacity building, research, and collaborations, the RBI is paving the way for a greener, more inclusive, and ethically governed economic future.

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