Reserve Bank of India Deputy Governor M Rajeshwar Rao said Climate change and its impact is increasingly being acknowledged as a key risk driver for the financial system by governments, regulators and financial firms.
Rao was speaking at CAFRAL Virtual Conference on Green and Sustainable Finance last week, Centre for Advanced Financial Research and Learning (CAFRAL) an independent think-tank set up by the Reserve Bank of India (RBI).
He said climate risk can impact the financial sector through two broad channels. Firstly, Physical risk, which is financial losses resulting from the increasing severity and frequency of extreme weather events. Secondly - transition risks which arise as we try to adjust towards a low-carbon economy.
It is important to understand these risk drivers which are likely to affect the financial firms, Rao added.
It is difficult to measure and quantify climate risk. The key elements of climate change outcomes are far-reaching impact on businesses, geographies, he explained.
Given the unprecedented nature of climate change outcomes, historical data and traditional backward-looking risk assessment methods are unlikely to adequately capture future impacts, Rao said.
He also said that climate risks may materialize over uncertain and extended time horizons which generally extend beyond typical financial and business cycles.
Financial firms and banks are exposed to climate related risk through its derivative impact on all risks which a bank or a financial firm face including underwriting risk, reputational risk & strategy risk, Rao said. It is important to recognise the impact of climate risk on financial firms and plan for it, he added.
Rao in his speech added that there is case to act early and ensure orderly transition. While transition costs may be higher in the short term, they are likely to trend much lower in the long run when compared to the costs of unrestrained climate deterioration.
He outlined the role of RBI and sustainable finance, he said, The Reserve Bank had already advised banks in 2007 to put in place an appropriate action plan towards making a meaningful contribution to sustainable development. Slowly and steadily, the Reserve Bank has been incentivising bank lending towards greener industries and projects.
On what RBI is discussing and contemplating, he adds, we have set up a Sustainable Finance Group (SFG) within the Department of Regulation in the Reserve Bank which will be spearheading RBI’s efforts and regulatory initiatives in the areas of sustainable finance and climate risk.
RBI is looking at integrating climate-based risk into financial stability monitoring, building in-house capacity on assessment and monitoring of climate risk, co-ordinating with other financial regulators related to a transition towards low carbon economy.
The central bank would look at advising regulated entities to have a strategy to address climate change risks and appropriate governance structures. The RBI will also explore forward looking tools like climate scenario analysis and stress testing for assessing climate-related risks.