Pratik Bakshi and Avantika
On 28 February, 2024, the Reserve Bank of India (“RBI”) released the Draft Disclosure Framework on Climate-related Financial Risks, 2024, for addressing climate-related financial risks and opportunities. The draft framework represents a significant shift towards sustainability and climate consciousness in India’s financial landscape and aims to establish a consistent disclosure framework for various financial entities.
In this framework, the RBI emphasized the need for Regulated Entities (“REs”) to provide more comprehensive information about their climate-related financial risks and highlighted that inadequate information can lead to asset mispricing and capital misallocation. The disclosure is intended to promote an early assessment of climate-related financial risks and opportunities, facilitate market discipline, and quickly integrate ESG risk identification and management into the organized sector, as REs will now require their borrowers to report both their emissions and their exposure to other climate risks.
Applicability of the guidelines
The draft framework shall be applicable to the following entities (collectively referred as REs):
a) All Scheduled Commercial Banks (excluding Local Area Banks, Payments Banks and Regional Rural Banks)
b) All Tier-IV Primary (Urban) Co-operative Banks
c) All All-India Financial Institutions (viz. EXIM Bank, NABARD, NaBFID, NHB and SIDBI)
d) All Top and Upper Layer Non-Banking Financial Companies
e) Foreign banks shall make disclosures specific to their operations in India
Other than these REs, adoption and compliance with the framework is voluntary.
Key Disclosure Requirements
Aligned with the international standards set by the Task Force on Climate-Related Financial Disclosures, the disclosure framework is expected to cover four thematic pillars:
a) Governance: This refers to how an entities’ board and management handle climate-related risks. The REs would be required to disclose how the board oversees these risks and opportunities, the role of senior management in evaluating and managing these risks and opportunities, including how climate-related considerations are factored into the remuneration of key personnel such as Whole Time Directors, Chief Executive Officers, and Material Risk Takers.
b) Strategy: This involves how climate change affects an entities’ business plans and how the entity adapts to these changes. The REs would be required to disclose the climate-related risks and opportunities it has identified over the short, medium, and long term and its impact on RE’s business, strategy, and financial planning.
c) Risk Management: This pertains to how REs identify, assess, prioritize, and mitigate climate-related risks, and how these processes are integrated into RE’s overall risk management process.
d) Metrics and Targets: This involves the metrics an entity uses to measure climate-related risks and the goals it sets to reduce them. The REs would be required to disclose the metrics it uses to assess climate-related financial risks and opportunities, absolute gross greenhouse gas emissions and financed emissions for each industry by asset class, including the percentage of assets vulnerable to these risks and the targets it uses to manage these risks.
The framework mandates these disclosures to be included in the RE’s financial statements on a standalone basis, rather than on a consolidated basis.
Timeline for Implementation
The RBI has outlined a phased plan for disclosures, with Governance, Strategy, and Risk Management pillars slated for disclosure by FY 2025-26 onwards, followed by Metrics and Targets by FY 2027-28 for all SCBs, AIFIs, Top and Upper layer NBFCs and a year later all Tier- IV UCBs.
Impact and Challenges
The implementation of this framework would require a significant overhaul of the existing portfolio evaluation methodologies, necessitating a portfolio risk assessment that incorporates climate risk into credit risk assessment. The current methodologies may not fully account for the risks associated with climate change, which can have significant impacts on the value of investments, the creditworthiness of borrowers and the effects of both physical and transition risks on liquidity and operational aspects. By incorporating climate risk into credit risk assessment, REs can make more informed decisions about their investments by identifying opportunities for sustainable investments that can contribute to the transition to a low-carbon economy.
The creation of governance structures for handling ESG risks is another crucial aspect of this framework. Governance structures set out the roles and responsibilities for ESG risk management within an entity and provide a framework for decision-making and reporting. Without effective governance, there is a risk that ESG considerations could be sidelined or not fully integrated into the RE’s operations.
In addition to these measures, scenario analysis also becomes imperative for REs to evaluate how their investments could be affected under different climate change scenarios, such as a rise in global temperatures or an increased frequency of extreme weather events. By analyzing these scenarios, REs can gain insights into how these potential outcomes could impact the value of their investments, the credit risk of their borrowers, or their operational resilience.
Conclusion
Aligned with the global sustainable finance initiatives, the proposed framework presents an opportunity for financial entities to proactively address climate-related risks, foster resilience, and sustainability within the financial system. While the proposed framework is a draft and REs have been requested to furnish their comments and feedback by the end of April, they must start developing strategies to seamlessly integrate this framework into their existing banking operations to effectively navigate the complexities of ESG risk management.