Climate risk refers to risk assessments based on formal analysis of the consequences, likelihoods and responses to the impacts of climate change and how societal constraints shape adaptation options. Common approaches to risk assessment and risk management strategies based on natural hazards have been applied to climate change impacts although there are distinct differences. Based on a climate system that is no longer staying within a stationary range of extremes, climate change impacts are anticipated to increase for the coming decades despite mitigation efforts. Ongoing changes in the climate system complicates assessing risks. Applying current knowledge to understand climate risk is further complicated due to substantial differences in regional climate projections, expanding numbers of climate model results, and the need to select a useful set of future climate scenarios in their assessments.
One of primary roles of the Intergovernmental Panel on Climate Change (IPCC), which was created by the United Nations Environment Programme (UNEP) and the World Meteorological Organization (WMO) in 1988, is to evaluate climate risks and explore strategies for their prevention and publish this knowledge each year in a series of comprehensive reports. International and research communities have been working on various approaches to climate risk management including climate risk insurance.
Natural disasters and diseases
According to the IPCC Fifth Assessment Report: “Impacts from recent climate-related extremes, such as heat waves, droughts, floods, cyclones, and wildfires, reveal significant vulnerability and exposure of some ecosystems and many human systems to current climate variability”.
The following future impacts can be expected:
- Temperature increases
- Extreme weather
- Bumper crops and crop failure
- Polar cap melting
- Changes to Earth’s eco-systems
- Disruption of the North Atlantic current
Mr. Kofi Annan, the erstwhile Secretary-General of the UN, remarked at the Paris Climate Agreement, “The world is reaching the tipping point beyond which climate change may become irreversible. If this happens, we risk denying present and future generations the right to a healthy and sustainable planet – the whole of humanity stands to lose”. These words ring truer today than ever before. There is no denying the fact that the climate of Earth has varied throughout its history given the vagaries of the forces of nature. However, multiple independent lines of investigation have provided increasingly compelling evidence that anthropogenic activities have significantly exacerbated the process of climate change since the industrial revolution.
As per the report of the UN’s Intergovernmental Panel on Climate Change dated August 9, 2021, the emissions of greenhouse gases (GHGs) from human activities are responsible for1.1°C of warming since pre-industrial times. While this change is seemingly small, the current temperatures are unprecedented in comparison to the levels over the past 12,000 years affecting living conditions in many parts of the world. Further, limiting global warming to close to 1.5°C or even 2°C over pre-industrial levels will be “beyond reach” without “immediate, rapid and large-scale reductions” in greenhouse gas emissions. This may have a profound adverse impact on the ecosystem, health, infrastructure and the economy. As per a recent study by Carbon Brief, a 1.5°C – 2°C temperature increase will shave nearly 8-13 per cent off the global GDP by 2100. The Global Risks Report 2022 published by the World Economic For ump resents the results of the latest Global Risks Perception Survey (GRPS) and an analysis of key risks emanating from the current economic, societal, environmental and technological events. According to the Survey, over the next five years, respondents signal societal and environmental risks to be of foremost concern. Over a 10-year horizon, environmental risks are perceived to be the five most critical long-term threats to the world as well as the most potentially damaging to people and planet, with “climate action failure”, “extreme weather”, and “biodiversity loss” ranking as the top three most severe risks.
Closer home, the latest annual report by the India Meteorological Department (IMD) on the country’s climate stated that 2021 was not only the fifth warmest year since 1901, but in the last decade, 2012-2021, was also the warmest on record. Moreover, 11 of the 15 warmest years on record were between 2007 and 2021. The rise in average temperatures could have a cascading effect on extreme weather events, crop patterns and urban disaster management. India recorded 756 instances of natural disasters(landslides, storms, earthquakes, floods, droughts, etc.) since 1900, with a total of 402 and 354 events recorded during 1900-2000 and 2001-2021respectively, indicating the preponderance of tail events of late.
A report of the Ministry of Earth Sciences, Government of India has concluded that since the middle of the twentieth century, India has witnessed a rise in average temperature; a decrease in monsoon precipitation; a rise in extreme temperature, droughts, and sea levels; as well as increase in the frequency and intensity of severe cyclones. There is compelling scientific evidence that human activities have influenced these changes in regional climate. These developments pose challenges for humanity and warrant an immediate, large-scale and rapid reduction in GHGs.
Concurrently, climate change is increasingly being recognized globally as a source of financial risk for banks. The uncertainty about the timing and severity of climate-related and environmental risk certainly threatens the safety, soundness and resilience of individual Regulated Entities (REs) and, in turn, the stability of the overall financial system. It is therefore recognized that the REs should steadily manage the risks and opportunities that may arise from climate change and environmental degradation. Further, with the increasing threat of climate change and the associated physical damage, change in market perception and shift in preferences towards more environmental-friendly products and services, the financial, reputational and strategic risk implications are becoming increasingly prominent.
Furthermore, recognizing climate-related financial risk may pose risks to global financial stability, Financial Stability Board (FSB) has chalked out a roadmap to ensure that climate risks are properly reflected in all financial decisions. The roadmap supports international coordination by bringing together the work of international organisations and national authorities on the various initiatives in this area. The FSB will focus on four pillars namely, disclosures, data, vulnerabilities analysis, and regulatory and supervisory approaches. More specifically, it would be monitoring and helping to support progress in the achievement of consistent climate related financial disclosures.
Strategy on Climate Change
Globally the efforts to address climate change have been growing across jurisdictions and an increasing number of central banks are either contemplating or are in the process of taking action on this aspect as part of their mandates. Further, climate change risk is also ascending the hierarchy of threats to financial stability across advanced and emerging economies alike and consequently, the need for an appropriate framework to identify, assess and manage climate related risk has become imperative. Notwithstanding the need to mitigate the risks arising out of extreme climate events, there is an increasing need for the financial system to move towards green financing, keeping in mind the social and developmental objectives of the country.
Therefore, keeping in view our national commitments and priorities, the Reserve Bank intends to prepare a strategy based on global best practices on mitigating the adverse impacts of climate change, learning’s from participation in standard-setting bodies and other international fora. The broad thrust of the strategy is presented under the following heads:
- Overview of climate related risk and its unique characteristics as applicable to REs
- Broad guidance for all REs to have (i) appropriate governance (ii) strategy to address climate change risks and (iii) risk management structure to effectively manage them from a micro-prudential perspective
- Exploring how forward-looking tools like stress testing and climate scenario analysis can be used to identify and assess vulnerabilities in REs
- Climate risk related financial disclosure and reporting for REs
- Capacity Building
- Voluntary Initiatives
Banks must learn to factor in
On July 24, 2022 RBI Governor Shaktikanta Das announced that the central bank will soon issue a consultation paper on climate risks for banks and financial sector.
The intent is to seek stakeholder views and suggestions for a more informed and measured approach towards preparing the banking sector to internalise climate risk.
The endeavour is in line with RBI’s April 2021 decision to join as a member of Network for Greening the Financial System (NGFS) — a coalition that brings together central banks and supervisors working on climate and green finance issues from across the globe.
Climate risk, even a decade back, was not a prerogative of either the policymakers, regulators, or the businesses. However, with the countries becoming increasingly exposed to climate related catastrophe (like wildfires in California, Australia, and Brazil) and extreme weather events (droughts or floods) often causing severe disruption in supply chain or hampering business continuity, the issue of climate change has come to the fore.
The risk is further compounded by mitigation related regulatory policies (say due to a carbon tax or cap on fossil fuel usage or banning of diesel cars) that imposes high adjustment costs for the businesses.
According to the 11th Annual EY/IIF (Ernst & Young Global Ltd. / Institute of International Finance) bank risk management survey released in 2021, over 91 per cent of the chief risk officers (CRO) and 96 per cent of the board members viewed climate change as the top emerging risk in the next five years.
Climate risks in the BFSI (Banking, Financial services and Insurance) sector can be classified into two major categories: (a) risks arising from economic costs and financial losses due to physical impacts of climate change (physical risks) and (b) risks precipitated by significant losses or cost of adjustment because of transition to a low-carbon trajectory (transition risks).
In a research report published in March 2022 by RBI titled ‘Green Transition Risks to Indian Banks’ there is a clear mention of the transition risk due to the cost of adjustment that falls in the production processes of industries that are directly or indirectly exposed to excessive use of fossil fuel.
Both these risks, arising out of climate related factors may eventually get manifested through traditional risk channels namely: (1) credit risk either due to reduced borrower’s ability to repay and service debt or bank’s inability to fully recover the loan because of default ; (2) market risk, say, due to reduction in the financial value of assets, and/or re-pricing of securities and derivatives due to stringent climate regulation; (3) liquidity risks on account of banks’ reduced access to stable source of funding because of changing market conditions; (4) operational risk due to legal and compliance risk pertaining to climate-sensitive investment; and finally (5) reputational risk due to changes in market and consumer sentiment due to changing consciousness on climate.
As traditional risk management approaches are not appropriate for measuring climate risks, regulatory authorities and businesses have opted for stress tests to assess the extent of a firms’ vulnerability to climate change.
The frontrunners in that direction include The Netherlands, France, Banking Union in Europe, the UK, Australia, Singapore, and Canada.
In Asia, the Hong Kong Monetary Authority has also started publishing climate risk guidelines and announcing future climate stress tests. The scenario in the BFSI sector globally is also progressively transforming to align with the imperative of internalising climate risk.
For instance, De Nederlandsche Bank (DNB) established a Climate Risk Working Group in 2016 and People’s Bank of China (PBC) standardised green disclosures and green credit ratings since 2018. The Financial Stability Board (FSB) created an industry-led Task Force on Climate-related Financial Disclosures (TCFD) to bring out climate-related information that are financially material.
Climate risks also find ample recognition in the European Central Bank’s (ECB) supervisory risk assessment and in the Climate Financial Risk Forum (CFRF) established by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority in UK.
In May 2021 SEBI mandated top 1,000 listed companies in India by market capitalisation to report Business Responsibility and Sustainability Report (BRSR) starting from the financial year 2022-23.
The reporting is expected to bring in greater transparency and enable market participants to identify and assess sustainability-related risks and opportunities, including climate risks. In the slew of these developments, a recent proposal by SEC (Securities and Exchange Commission) floated in March 2022 in the US on climate-related disclosure rules for public companies, which includes banks and other financial services groups, also deserves special mention.
Although the wind has started to blow in the right direction, a critical question that remains to be explored in the Indian context is whether the stakeholders in the BFSI sector, especially the banks, are ready to internalise climate risk.
A recent survey in March 2022 by Climate Risk Horizons (CRH), a think-tank, analysed 34 largest scheduled commercial banks in India by market capitalisation on the Bombay Stock Exchange (BSE) representing ₹26.81 trillion as on March 31, 2021. They inferred that only a handful of Indian banks have factored in climate risk, albeit only partially, in their business strategies.
Challenges for banks
Internalisation of climate risk factors by banks is very much on the agenda especially with RBI taking up the cudgels. However, given the complexity in climate risk modelling, the biggest challenge for a bank would be to measure the impact of climate risk while undertaking lending and investment decisions and further integrating that risk in the existing risk and valuation frameworks.
According to a recent Bloomberg survey for European banks, most banks reported that they could only confine themselves to a qualitative assessment of climate risks during the loan approval processes, which could at best be considered as subjective. The quantification of climate risk, albeit crucial, may require quality data that is not always available due to inadequate and at times inconsistent corporate disclosure.
The second challenge that a bank faces is dearth of standardised industry models to embed climate risk into enterprise risk management framework.
The third critical challenge is the lack of skilled professionals who have clear understanding of both the worlds — climate risk and finance.