Amending Banks’ ways of measuring climate risk exposuresSagar Asapur, Sustainable Finance Lead, Climate Risk Horizons
The New Delhi Declaration at the recently held G20 Summit put a renewed focus on the role of financial institutions, multilateral funds and private finance in implementing climate action. The declaration has acknowledged that developing countries require about USD 6 Trillion dollars by 2030 to implement their climate commitments and USD 4 trillion per year for energy transition. Measuring how financial institutions are exposed to climate risks is crucial for financial oversight. Assessing and managing climate risks for financial institutions, therefore, is no more a matter of ethical business but a core fiduciary responsibility.
The Basel Committee on Banking Supervision (BCBS) - the global financial regulation architect - has explored the banking system’s exposure to climate change through macro and micro-economic transmission channels arising from climate-related risk drivers, viz. physical and transition risks. Given the profound implications of the climate crisis on every economic sector and industry, analysing the industry-wise exposure of a financial system is essential.
Recent analysis by Climate Risk Horizons (CRH) of India’s 30 largest banks under Basel III standards reveals, as might be expected, that both public and private sector banks have significant exposures to the energy, metals and chemicals sectors. These banks face high transition risks due to their investments in carbon-intensive firms in these sectors.
Data that monitors sectoral exposure of the Indian banking system through a climate filter is important, and for this to be truly useful in designing policy incentives, both availability and consistency in reporting are essential. This is lacking right now: for example, some banks use 'Power' interchangeably with 'Energy’, others categorise energy into electricity generation, transmission, and distribution, most do not separate clean energy generation from conventional, etc. This underscores the need for the Reserve Bank of India (RBI) to regulate disclosures to enhance consistency, accuracy and transparency.
Classification of sectors
In categorising economic activities into various sectors, India's National Industrial Classification (NIC) system is used as a basis for industry classification by public authorities and financial institutions, and it faces challenges applying it to climate-related financial risks including the banking sector. The rapidly evolving climate finance landscape complicates accurate characterisation. The NIC’s lack of granularity might hinder accurate classification of climate-related activities, especially for banks engaged in traditional and sustainable financing. This ambiguity leads to inconsistent reporting of green finance initiatives. The NIC also struggles to classify cross-sectoral activities’ interconnectedness between the banking sector and climate-related initiatives like renewable energy and sustainable infrastructure. Addressing these challenges and aligning the NIC with climate risks in banking practices can enhance accurate industry analysis and regulatory oversight.
Aligning sectoral classification of economic activities is vital for evaluating transition and physical risks. It helps to measure greenhouse gas emissions and financial risks associated with climate hazards at regional/local levels, affecting sectors like agriculture, transportation, etc., and labour-intensive industries, like construction. At times, sub-sector classifications are necessary: for instance, power is considered a single sector, but reporting on renewables as a sub-sector provides a clear metric to assess individual bank performance in meeting India’s climate targets. Such risk classifications can simplify operational processes and be useful for banks and supervisors in monitoring concentration risk and strategic planning.
Data is indispensable to effectively measure and mitigate climate risks. Geolocational data can capture physical damage risks as well as transition risks associated with specific industrial sectors. Assessing vulnerability to climate risk requires data on sectors and sub-sectors and then integrating that data into finance, risk, and compliance systems. Banks should evaluate the ability of their data management architecture to compute economic and regulatory risks under different climate change scenarios.
For well-run institutions, banking is a profitable sector - it is prudent to invest some of these gains in anticipation of future high compliance costs due to mandatory disclosure requirements of regulators. This allocation should be directed towards development of resources, IT infrastructure, technical capabilities, and other areas essential for managing climate risks. The RBI released a paper on climate risk and sustainable finance disclosure rules a year ago, but has yet to finalise them. One hopes that the RBI will move quickly and instruct banks accordingly, and banks should be prepared. Institutions must prepare for changes in their data management processes to meet data needs, including consistent information on climate risk drivers, vulnerability of counterparties, sectors, and regions to these risk drivers, their ultimate impact on bank portfolios, as well as potential impacts on the financial system.
Metrics and indicators
Translating climate-related risks into quantifiable financial risk metrics, broken down by sector and even adjusted for company-specific aspects is going to be essential. Carbon intensity metrics like CO2 emissions per unit of energy or distance driven can serve as proxies for transition risks, along with qualitative information on the client's climate strategy and vulnerability. Metrics for physical risks at the portfolio-level enable identifying geographical risk concentrations and hazard types, and assessing probability and potential severity of such risks.
The RBI’s role
It is crucial for supervisors such as the RBI and SEBI to evaluate inclusion of material climate-related financial risks in banks' risk management frameworks. This assessment ensures that banks adequately consider all relevant climate-related financial risks. Additionally, their data aggregation capabilities and internal reporting practices facilitate identification and reporting of climate-related risk exposures, concentrations, and emerging risks.
Today, even as the climate crisis continues to gather pace, banks' business models continue to exacerbate the impact of climate-related risks. Prudential regulation remains slow: there are no specific climate-related constraints on capital requirements for banks, and no standardisation of reporting on climate metrics, including the transition investments so badly needed if India is to move towards a low carbon economy.
The mandatory integration of climate risk into banks' balance sheets, incentives for transition to green financing and adoption of a common methodology set by the RBI in consultation with banks must be on the table.
The record-breaking monthly global temperatures of 2023 and the devastation unleashed by extreme climate events have underlined the need for comprehensive assessment and management of climate-related risks by banks. Fiduciary responsibility leaves no other option. Further delays will prove detrimental, compromising New Delhi Declaration for climate action and India's standing in the global financial market. As the financial landscape shifts rapidly under climate pressures, integration of climate risk into core operations, capital requirements, and business models remains not a choice, but a vital prerequisite for sustaining economic strength and global competitiveness.