RBI’s proposal for a disclosure framework to ascertain climate-related financial risks | Explained Premium

The Reserve Bank of India (RBI) presented draft guidelines on the Disclosure framework on Climate-related Financial Risks, 2024. We examine the guidelines and the type of disclosures envisaged by them.

The story so far: Seeking to institute a framework for regulated entities to tackle climate-related financial risks, the Reserve Bank of India (RBI) on February 28 presented draft guidelines on Disclosure framework on Climate-related Financial Risks, 2024. The Statement on Developmental and Regulatory Policies, presented along with the Monetary Policy statement on February 8, 2023, had recognised that climate change can translate into financial risks for regulated entities. It further held that this could have broader financial stability implications. Comments and feedback on the draft framework are invited until April 30. 

According to the regulator, climate-related financial risks may emanate either directly from climate change events or as an outcome of efforts to mitigate climate change. In the build-up to the latest draft guidelines, the RBI had released a discussion paper on Climate Risk and Sustainable Finance in July 2022. Broadly, the paper categorised potential effects into physical risks and transitional risks.  

Physical risks refer to economic costs and financial losses as a consequence of the increasing frequency and severity of extreme weather events (like heatwaves, landslides, storms and wildfires), long-term gradual shifts in climate (such as extreme weather variability, rising sea levels and ocean acidification, among others) and indirect effects (like degradation of soil quality or marine ecology, among others). The impact may vary subject to geographical locations. Although, any exposure to such risks may stress an entity’s cash flows, the primary risk emerges out of a potential disruption of a corporate value chain or lower economic or sectoral activity. Further, events such as chronic flooding or landslides may risk the value of a collateral (especially immovable property) taken as security against loans. Severe weather events could also damage banking entity’s properties or data centre assets, impacting their ability to provide services to customers.  

The other set relates to transitional risks, meaning associated risks caused by a transition to a low-carbon economy. This could manifest in a potential downgrade in credit ratings or financial valuation because of a climate mitigation policy or introduction of incentives encouraging the use of energy efficient means. It may entail increased costs or an overhaul of operations. Technological innovations (towards clean energy) could depreciate the value of (existing) assets dependent on older technologies, leading to a reduction in the cash flow of certain borrowers.

Shifts in public sentiment also have a role to play. This refers to an increased preference for savings, projects and/or investment instruments with more climate-friendly policies and fostering a positive impact on the environment. 

Banks may face credit risk should their customers’ value of assets depreciate, or if their supply chains are impacted affecting operations, profitability and viability. This would impact the borrower’s capacity to service or repay debt, with the lender unable to fully recover losses.  

At the same time, climate change can spur a demand for liquidity. This can be in response to extreme weather events or consumers perceiving future difficulties in liquidating their assets if a climate event has a negative impact. This may in turn impact an entity’s capacity to raise funds and address obligations. Banks also stand the risk of not meeting their exposure to claims (say, against insurance products) from customers who are seeking to recover their climate-related losses. This could be particularly acute if there is a heavy concentration of a vulnerable sector in their portfolio.