Sustainable Finance and Financial Institutions

Introduction

Mr. Kofi Annan, the former Secretary-General of the United Nations, expressed during the Paris Climate Agreement that the global community is approaching a critical juncture where climate change may become irreversible. Achieving the goal of limiting global warming to around 1.5°C or 2°C above pre-industrial levels is deemed practically unattainable without urgent, substantial, and widespread reductions in greenhouse gas emissions. A recent study suggests that a temperature rise of 1.5°C - 2°C could reduce Global GDP by approximately 8% to 13% by the year 2100. The Global Risks Report 2022 by the World Economic Forum indicates that Climate Action Failure, Extreme Weather, and Biodiversity Loss rank as the Top \'Three Severe Risks\'.

Climate Risk-Relevance in Financial Sector

Climate change is advancing at an increasing rate, leading to a rise in both the frequency and financial impact of climate-induced natural catastrophes. The tangible impacts of climate change, coupled with the accompanying costs of transitioning, present notable hazards within the realm of the Economy and Financial System.

• Physical Risk: Pertains to the potential harm to individuals and assets resulting from discrete climate-related incidents like hurricanes, wildfires, and heatwaves, in addition to longer-term phenomena such as alterations in precipitation patterns, rising sea levels, and increased average temperatures.
• Transition Risk: Denotes the strain on organizations or sectors due to actions aimed at transitioning to a less carbon-intensive economy, encompassing responses to policy adjustments, adoption of novel technologies, and adaptation to changing consumer and investor preferences.

Climate-related physical and transition risks often materialize as conventional financial risks, including Credit, Liquidity, Market, and Operational Risks.

Climate-related Financial Risk Examples

• Disturbances in Economic Operations resulting from climate-triggered weather events might impact household earnings and their capacity to meet financial obligations/repayment of debts.
• The shift in consumer preferences from gas-fuelled vehicles to electric and hybrid ones may affect the collateral value of automobiles.
• Deficiencies in how a Credit Institution / Financial Institution identifies, assesses, supervises, and alleviates physical and transition risks could negatively impact the institution\'s stability and strength.
• Low-income and minority communities exhibit a heightened susceptibility to financial risks stemming from climate-related factors.
• Insurers and reinsurers face significant physical risks on their asset side, and additional risks from the liability side due to increased claims.
• Central Banks / Financial Regulators are increasingly recognizing the financial stability implications of climate change and may need to adjust monetary policy, potentially imposing larger haircuts on assets exposed to physical or transition risks.

Risk Scenarios in Agricultural Finance

• Situation-1: A farm funded by Financial Institutions fails to adapt its crop rotation to cope with reduced annual rainfall, leading to lower crop yields and loan default. Conversely, institutions providing advisory services for climate-resilient crop rotations may witness an expansion in market share.
• Situation-2: A borrower experiences a drop in sales because their crops/livestock are not produced using low greenhouse gas emission technologies, leading to loan default.

Terminology utilized and yet to be defined in legislations in India in financial sector

• \"Climate-related Financial Risks\": Potential risks associated with climate change or measures taken to address climate change.
• \"Climate Resilience\": The ability of a Renewable Energy (RE) entity to adapt to climate variations, developments, or uncertainties.
• \"CO2 Equivalent\": Standardized unit to indicate the global warming potential of individual greenhouse gases relative to carbon dioxide.
• \"Financed Emissions\": Percentage of total greenhouse gas emissions of a recipient/counterparty attributed to financial support provided by an RE.
• \"Greenhouse Gases (GHGs)\": Gaseous components in the atmosphere, primarily carbon dioxide (CO2), methane (CH4), and nitrous oxide (N2O).
• \"Physical Risk\": Financial losses from acute and chronic physical risks, and secondary impacts of climate change.
• \"Scenario Analysis\": Exploring potential scenarios that deviate significantly from \"Business-as-Usual\" practices.
• \"Scope-1, Scope-2, and Scope-3 Greenhouse Gas Emissions\": Direct emissions, indirect emissions from purchased electricity/steam, and other indirect emissions throughout the value chain respectively.
• \"Transition Risk\": Risks associated with the adjustment process towards a low-carbon economy.

IFRS Climate-related Disclosures

The objective of IFRS S2 is to mandate entities to disclose information regarding their climate-related risks and opportunities that could reasonably be expected to affect the entity\'s cash flows, access to finance, or cost of capital over the short, medium, or long term. IFRS S2 applies to climate-related physical and transition risks, and climate-related opportunities. It requires disclosure of governance processes, strategy, risk management processes, and performance metrics/targets related to climate.

Conclusion

Climate Change is an existing reality. Policymakers and investors are progressively acknowledging the significant implications of climate change for the financial sector. The financial system is impacted by climate change through physical risks and transition risks. Lower- and middle-income economies tend to be more susceptible to physical risks. Financial institutions can face direct and indirect manifestations of physical risks, leading to increased default risks in loan portfolios or reduced asset values.