How can Indian banking become climate (change) friendly?

Last year, the well-known band Coldplay released a?sustainability report?on carbon emissions from its ongoing world tour. It produced 47% less CO2 emissions compared to its 2016-17 tour; its shows were powered from 100% renewable energy; and the band planted one tree for each concertgoer (adding up to a whopping five million trees!).?

This left many guessing at numbers and figures, pulling the puzzle apart – what was the cost of sustaining this very green tour??

Coldplay?earned?$85 million from the tour’s South America and Europe leg. The band recently wrapped up shows in Asia and is due to take the tour to Australia later this year – which will surely add to the revenue numbers.?

Here’s the thing – lenders can learn a thing or two from Chris Martin and his men – balancing the risks and rewards of sustainability.??

Carbon emission sustainability – new order, opportunity, or liability??

The Paris Agreement represents a rare show of international solidarity – 195 countries (nearly the entire world) have now signed a historic global accord to arrest global temperatures to 1.5°C above pre-industrial levels by reducing greenhouse gas emissions. And India, one of the world biggest polluters, will especially be observed to make good on its commitment.?

It is safe to say that achieving carbon emission sustainability is the new reality – whether or not it seems to be in the vested interests of crucial players like industries, individuals, and banks. However, an RBI survey found that banks were largely?unprepared?for more advanced ESG standards. Moreover,?not one Indian bank is a member?of the Net Zero Banking Alliance.?

Lenders, now more than ever, need to decide whether they view this new order as an opportunity or a liability for their business.?

The opportunity of going green

1. The Glasgow Financial Alliance for Net Zero (GFANZ) has?allocated?$130 trillion to net zero.
2. There is a?growing retail consumer interest?and demand in climate-linked banking products like green deposits – 40% of users surveyed in the US.
3. Renewable energy projects can be?financed?through Priority Sector Lending, helping banks reach closer to their targets.?

The risks of going green

Even though the opportunity of sustainable finance for lenders is massive, capital reallocation to this segment will pose several risks – physical and transitional. Let’s break it down.?

1. Physical risks?

These are the losses and costs lenders might incur from extreme weather events and calamities, gradual but chronic changes in climate like rising temperatures and sea levels, changes in precipitation, and the indirect impact of climate change like poor soil quality and water shortages.?

These would impact the expected cashflows from affected regions, deterioration of the value of collaterals held by banks, or even operations due to damages to a lender’s physical properties.?

2. Transition risks?

As economies adjust to a low-carbon regime, their lenders are expected to face risks like devaluation of businesses on their loan books, or subsidised energy transition to non-fossil fuels. New, efficient innovations could render banks’ assets dependent on older technologies stranded.??

Retail consumer interest in greener financial products could result in a growing demand for investment of their deposits and savings to projects with a higher environmental impact.

Climate-linked financial risk management?

Yes, the risks are daunting, but the opportunity is too massive to be squandered. The good news is, regulators, industry players, and new disruptors are all trying to help lenders realise the opportunities while minimising the risk.??

This is being done by making governance more responsible, conducting macro-level vulnerabilities analyses to ascertain the impact of climate risks on financial systems, and creating disclosure frameworks to help lenders disclose information about risks and opportunities that can help with early assessment.?

But data and technology have a vast untapped potential in climate-linked financial risk management.

Mitigating transition risk?

Two major conundrums stump lenders when it comes to transition risk:?

1. What can lenders do about existing high carbon-emitting portfolios in their efforts to go green??

2. How should lenders underwrite new green tech and projects without historical records attesting to their creditworthiness??

There is a simple and elegant answer to both these problems. But first, let's examine them further —??

1. According to a?Moody’s analysis, 25% to 35% of the loans in India’s banking system are exposed to sectors like coal mining, diesel-reliant logistics, coal-fired power generation, and oil and gas. That represents a large chunk of its banks’ portfolios, abandoning which would be disastrous for the lending business. This is where the concept of?transition finance?comes in – this is financing diverted towards high carbon-emitting industries that helps them fund their decarbonisation efforts. Innovative as it may be, transition financing requires thorough risk checks and assessment to achieve its goal. And current credit rating criteria for businesses fall painfully short of assessing firms’ ESG performance or sustainability commitments.?
2. Climate technologies and solutions across the board – non-fossil fuel power generation, EVs, and more – are in early stages of development. The lack of historical financial data and by extension, credit ratings, around these makes it difficult for lenders to underwrite businesses manufacturing or utilising them.??

Lenders must develop an efficient system for?carbon credit verification?to?equitably allocate credit across transition finance and to fund new projects and tech. One way to think of this is as a green credit score built on alternative data sourced from across a variety of data and tech providers like weather monitors, soil quality assessment, meteorological data – the examples are endless!?

In fact, the role of digital public infrastructure in creating an efficient carbon market is severely unexplored. As per reports, a piece of?DPI for climate finance?is already in the works in India. This could potentially have applications in the development of not only a carbon credit verification framework, but also ensuring transparency in carbon transactions.?

Conclusion

It is time that lenders stop viewing their ESG mandates and regulatory requirements as liabilities. Green financing is very much a reality – and the commercial opportunity for banks in both retail and corporate terms is tremendous. Banks' current digital transformation needs to be reimagined so that they can play their critical role transitioning entire economies to net zero.?

Cheers,

Rajat