[Shivam Bhattacharya is a 5th year and Subhasish Pamegam is a 3rd year law student at Gujarat National Law University, Gandhinagar]
In a significant development, the Reserve Bank of India (“RBI”) has published the ‘Draft Disclosure Framework on Climate-related Financial Risks, 2024’. The framework mandates the Indian financial institutions (“FIs”) to incorporate climate-related assessments into their mainstream compliance. Seen as an attempt towards aligning the Indian financial sector with global standards, the move underscores the RBI’s commitment to addressing climate risks, which pose a significant threat to financial stability. With the RBI itself classifying climate-related financial risk as a systemic risk in 2020, the present notification assumes increased significance to address concerns regarding ‘mispricing of assets and misallocation of capital’ arising out of these risks.
This post provides an analysis of this framework and the potential challenges which the FIs would face in implementing the regulation. It also delves into the ways through which it can be harmonized with the business responsibility and sustainability reporting (“BRSR”) mandate and provides some suggestions that would help in tackling the challenges discussed throughout the post.
Decoding the RBI’s New Climate Disclosure Framework
The draft framework provided by the RBI mandates compulsory disclosures focussing on four broad pillars (“Thematic Pillars of Disclosure”): (i) governance, (ii) strategy, (iii) risk management and (iv) metrics and targets. The FIs would be required to integrate climate risk into their existing financial models, which traditionally do not account for the long-term and uncertain nature of these type of risks. This would necessitate the development of new technologies and advanced data collection and analysis capabilities, requiring substantial investment and expertise. Smaller Fis, in particular, may find this transition difficult.
The phased implementation approach adopted by the RBI provides for a four-year roadmap wherein FIs would be required to start disclosures from FY 2025-26, thereby providing them with sufficient time for capacity building and adoption. It provides that FIs disclose climate risks in their financial statements, covering short, medium, and long-term impacts on business strategy and financial planning. This aligns with the internationally recognized ‘Task Force on Climate-Related Financial Disclosures’ (“TCFD”) structure with the primary focus being put on governance, strategy and risk management for managing climate-related risks.
Additionally, the framework provides that the FIs should make use of ‘scenario analysis’ and set internal targets aligned with legal benchmarks. To make the system more effective, the regulatory body has provided that the disclosures would be required to pass stringent internal controls assessment, after being reviewed by the board of directors in order to ensure that consistent and reliable data is being disclosed. These disclosures need to be made on a standalone basis in order to cater to different stakeholders such as customers, investors, depositors and regulators. Another crucial aspect provided in the notification is the implementation of ‘climate stress tests’. These tests are vital for assessing the resilience of institutions to climate-related shocks, requiring sophisticated modelling tools and scenario analysis techniques. This development necessitates significant financial investment and technical expertise by the FIs.
Even as the framework aims to bolster the financial sector against climate risks, it presents considerable technical and operational challenges relating to compliance. The next part focuses on this aspect.
Compliance Challenges for Indian FIs in Implementing RBI’s Regulation
The draft regulation marks a significant step towards integrating sustainability considerations into the operations of Indian FIs. However, this step towards sustainability is not without challenges. Several compliance-related challenges loom large, warranting a critical examination of the readiness of Indian FIs and the hurdles they may encounter in implementing the draft regulation.
Disclosure of Financed Emissions: A Daunting Task
One of the primary challenges that Indian FIs may face in climate-related risks disclosure is accurately disclosing financed emission. The collection of emission data from diverse clients across various sectors, asset classes, and geographic regions presents a daunting task, compounded by the lack of standardized reporting frameworks. FIs currently face challenges with incomplete, inaccurate, or inconsistent data provided by companies for calculating emissions, revenue, or production, especially due to the voluntary nature of emission reporting. This leads to a reliance on estimates or averages, potentially resulting in underestimation or overestimation of emissions, dependence on external data sources or manual processes, inaccurate performance assessments, and discrepancies in reported progress towards targets.
To ensure reliability of such disclosures, companies can obtain environmental, social and governance (“ESG”) certificates, which cover various industries, topics, and asset types, to showcase their sustainability efforts. They can then submit these certificates to banks, outsourcing the data collection process to the certificate issuers. This approach would simplify procedures for banks, relieving them from the burden of collecting ESG data and ensuring its integrity. Furthermore, referencing standardized data points from certificates could help fulfil regulatory reporting requirements and audit evidence obligations.
Mapping Risks Associated with Existing Loans and Investments
Mapping climate-related risks associated with existing loans and investments requires a thorough understanding of the climate-related risks inherent in each financial transaction. Financial institutions must assess the exposure of their portfolios to physical risks (e.g., extreme weather events) and transition risks (e.g., regulatory changes impacting carbon-intensive industries). Conducting materiality assessment to identify and prioritize ESG issues relevant to each sector is crucial for accurately pricing the climate-related risks for the concerned industry. This step ensures that financial institutions address the most significant ESG issues impacting their sectors, thereby enabling more informed decision-making and risk management practices.
Lack of Guidance on Scenario Analysis
Another significant gap in the draft regulations by the RBI is the lack of specific guidance on conducting scenario analysis by the FIs. Scenario analysis involves projecting various potential future scenarios and assessing how each scenario would impact the financial institution’s operations, assets, and liabilities in the context of climate-related risks. However, the lack of clear directives on conducting such analyses, including which scenarios to consider, what data to utilize, and how to interpret the results, FIs may struggle to perform accurate assessments. These challenges stem from the complexity of handling multiple scenarios, variables, assumptions and models. This lack of clarity could result in inconsistencies in approach among different entities, leading to difficulties in comparing and interpreting disclosures. A joint-study published by the Network for Greening the Financial System (“NGFS”) suggests that climate-related risks are understated because these analyses overlook second-round effects, such as losses incurred by insurance firms and the expenses associated with risk mitigation measures aimed at limiting these losses.
Therefore, it becomes imperative to emphasize greater international cooperation and the development of standardized methods for conducting scenario analysis. By adopting a standardized approach, FIs can overcome the challenges associated with methodological complexity and data interpretation, facilitating more accurate and consistent assessments of climate-related risks.
Harmonising RBI’s Framework with BRSR Mandate
The SEBI’s BRSR mandate for the top 1,000 listed entities in India emphasizes the growing importance of ESG considerations in corporate disclosures. By incorporating learnings from the SEBI BRSR mandate, the RBI framework can enhance the effectiveness of climate-related financial disclosures and risk management practices. However, the BRSR mandate does not include TCFD recommendations, with the exception of reporting on Scope 1, 2, and 3 emissions data. To bridge this gap, the RBI framework can prioritize the adoption of a comprehensive disclosure framework that encompasses all TCFD recommendations, including those related to governance, strategy, risk management, and metrics and targets. Unlike the BRSR mandate, which primarily focuses on sustainability reporting, the RBI framework can emphasize the integration of climate-related financial risks into core business practices.
One key aspect of integration involves aligning governance structures with TCFD recommendations to facilitate effective oversight and management of climate-related risks. This includes ensuring board-level accountability, establishing clear roles and responsibilities, and integrating climate considerations into strategic decision-making processes. By synchronizing governance and strategy with TCFD recommendations, FIs can enhance their resilience to climate-related risks and capitalize on emerging opportunities. The RBI framework should emphasize the establishment of robust metrics and targets for tracking and measuring climate-related performance. This involves quantifying greenhouse gas emissions, assessing climate-related opportunities and risks, and setting targets for emissions reductions and transition strategies. By setting clear metrics and targets aligned with TCFD recommendations, the FIs can enhance transparency and accountability in their climate-related disclosures.
Furthermore, considering the large number of FIs (such as scheduled commercial banks, tier IV primary urban co-operative banks, All India Financial Institutions such as EXIM Bank, NABARD, SIDBI etc., NBFCs and foreign banks operating in India) covered under the RBI framework, a phased approach to reporting, similar to the BRSR mandate, could be adopted. This would involve commencing with voluntary disclosures and gradually transitioning to compulsory reporting for larger banks, taking into account their scale and business operations. The RBI can establish a criteria for determining which institutions are subject to mandatory reporting, considering factors beyond just size, such as systemic importance and risk profile.
Conclusion
The framework marks a significant step towards the creation of a resilient and sustainable financial system. The adherence to the legal standards set out, mapping risks associated with existing investments and mutual collaboration amongst the FIs would determine the success of this initiative. While smaller FIs may face several challenges related to compliance, the phased approach and emphasis on robust governance and risk management practices would greatly contribute to its proper implementation. On its part, the regulator would have to ensure that the highest levels of transparency and accountability is maintained, and any concerns regarding the framework’s implementation are swiftly addressed.
– Shivam Bhattacharya & Subhasish Pamegam