A new climate for regulating financial risk

In its February 2024 statement on developmental and regulatory policies, the Reserve Bank of India (RBI) explicitly recognised that “climate change can translate into climate-related financial risks” for regulated entities (RE) “which can have broader financial stability implications”. To align with global best practices, the RBI in July 2022 placed a discussion paper on climate risk and sustainable finance on its website for public comment.

Based on the feedback received, the RBI’s February 2024 statement proposed issuing a framework for green deposits, a disclosure framework for climate-related financial risks, and guidance on climate scenario analysis and stress testing. On 28 February 2024, the RBI issued draft Guidelines on Disclosure Framework on Climate-related Financial Risks for public response. While Pillar 3 disclosures under Basel III already require material risk to be revealed, the disclosure framework seeks to put in place a mechanism for REs to communicate more structured information about climate risks.

The disclosure framework if finalised in its draft form will apply to all scheduled commercial banks, all top-layer and upper-layer non-banking financial companies (NBFC) and certain other financial institutions. REs other than these may adopt the disclosure framework on a voluntary basis. The draft framework recognises the need for “a better, consistent and comparable disclosure framework” as “inadequate information about climate-related financial risks can lead to mispricing of assets and misallocation of capital”. The guidelines also recognise that climate-related disclosures are an important source of information for stakeholders in understanding climate risks and the mitigation measures adopted.

The draft disclosure framework requires REs to disclose climate-related risks in their financial statements, thus promoting early assessment of climate-related risks. These disclosures would need to be made on a standalone basis. Climate-related financial risks are defined as potential risks that may arise from climate change or efforts to mitigate climate change and its economic and financial consequences. The draft disclosure framework also defines more non-financial technical terms, such as CO2 equivalent, financed emissions, greenhouse gases, Scope 1 greenhouse gas emissions, and Scope 2 greenhouse gas emissions. Transition risks are defined as those risks related to the process of adjustment towards a low carbon economy, such as changes in climate-related policies and regulations, emergence of new technologies and shifts in consumer preferences and behaviour.

Climate-related disclosures for REs would cover four “thematic pillars”. These are governance, where REs are required to disclose governance processes to identify, assess and mitigate climate-related financial risks and opportunities and the board’s oversight of climate-related risks and opportunities. The senior management’s role in assessing climate-related risks and opportunities is also included under this head. The second is strategy, in which REs must disclose identified climate-related risks and opportunities in the short, medium and long term, the impact of climate-related risks and opportunities on the RE’s businesses and the resilience of the RE’s strategy based on different climate scenarios. Risk management is next, where REs identify, assess, prioritise and monitor climate-related financial risks and opportunities and how these integrate with their overall risk management processes. Finally, metrics and targets require REs to explain their performance in respect of their climate-related financial risks and opportunities, their progress towards any climate-related targets and any targets required by local laws.

This framework’s conceptualisation is far-sighted, reflecting a regulatory stance that is at least in step, if not ahead of the market. The disclosure framework, if implemented in its present form will be an instance of regulation guiding market development rather than merely reacting to it. The draft guidelines are to be lauded for trying to create a framework emphasising climate change disclosure rather than imposing hard targets. This nuanced approach and its interlinking with risk-based disclosures in financial statements might actually be a potent force in promoting climate discipline.

Sawant Singh and Aditya Bhargava are partners at Phoenix Legal.