Including climate change in policies is crucial for a strong economy

As the world grapples with the repercussions of legacy emissions, there is growing pressure to achieve climate compatible growth. Fiscal and monetary authorities will now need to be aware of the impact of climate change on the economy and adapt their policy responses accordingly. Exposure of assets to extreme weather events and loss of asset value due to a green transition are imminent risks to the financial system.

Yet the inclusion of climate change in a central bank’s policy response function is a widely contested issue. Some experts see no harm in the bank’s internal assessment of the impact climate change would have on the economy, but are reluctant to ask the bank to actively set monetary policy based on such assessments. Others argue that climate change is a significant threat to financial stability and that a central bank that does not address climate risk is “not doing its job”.

Central banks can guide the flow of finance by limiting the flow of credit to sectors dependent on fossil fuels. Central banks are adopting a range of best practices and approaches. For example, the Banque du Liban sets different reserve requirements for loans related to energy savings. The People’s Bank of China provides positive incentives for commercial banks to provide green credit and India includes renewable energy (RE) in lending to priority sectors.

The RBI was measured but receptive to addressing the concern. In 2021, it joined the Network for Greening Financial System, a voluntary group of 116 central banks that promotes the exchange of best practices in green finance. In July 2022, she published a discussion paper that covers the issue of climate risks and sustainable finance. The paper seeks to understand preferred approaches for identifying and disclosing climate-related risk exposures, risk management frameworks, and capacity building within the banking sector.

Considering change, the RBI paper indicates an interest in understanding the degree of physical and transitional risks. At the same time, it reflects that RBI prefers to be cautious in assessing the readiness of the system rather than indicating its own approach to what a central bank can do. The RBI’s approach is reasoned since risk recognition is a double-edged sword. Failing to recognize the risks portends complacency, while anticipating all those risks through regulation means that already stressed loan portfolios will be compounded. The document therefore enables the RBI to respond based on existing practices and a better understanding of banks’ risk profiles.

Previous RBI research papers also point to a growing recognition of risks to the financial system. In 2021, an RBI research paper demonstrated that extreme weather events can increase inflation – as demonstrated by wheat prices this year. In 2022, RBI estimated the exposure of Indian banks to the green transition. The report found that public and private banks’ direct exposure to three fossil fuel-based sectors – power, chemicals and automotive – may not be “unalarming”. Nevertheless, indirect exposure via other sectors of the fossil fuel value chain should also be closely watched, given that some already have bad debts.

Both reports indicate the need for further risk assessment. To add to this, the risk to government borrowing from falling fossil fuel revenues must also be established. As the wheels turn within RBI, the disclosure and risk assessment frameworks are a starting point. It remains to be seen what macro and microprudential regulations RBI will introduce. Moreover, the scope of the discussion in the paper remains limited and without a general narrative on the role of the central bank. It does not detail the different instruments such as capital requirements for fossil fuel-based loans by banks or credit guidelines that a central bank can work with to ensure the greening of the financial system.

The RBI’s consultation paper shows the bank’s readiness to deal with climate change risks. This indicates that regulatory changes are in sight, but their direction remains unknown. Moreover, it leaves to the imagination whether climate change will be a key consideration for monetary policy. A point that deserves due consideration is that a comprehensive assessment of the macro-risks associated with the divestment of fossil fuel-based assets requires a clear identification of the horizon for phasing out fossil fuels in all sectors. . Although these are outside the purview of the RBI, it is a prerequisite for the comparability of risk assessment carried out by financial institutions, thus forming the basis of regulation. The publication of the document is therefore only the beginning and requires an overall net zero plan for the disclosures to be used objectively.

The author is Assistant Professor, NIPFP

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