India’s financial system needs a green taxonomy to build resilience to climate risks, Energy News, ET EnergyWorld

Sustainable finance markets globally are grappling with two major issues: capital not reaching the assets that need it most and greenwashing. Both problems stem from weak policy frameworks and unclear implementation mechanisms.

Recent investigations in Europe against DWS, German Bankthe asset management arm of, and in the United States against Goldman Sachs regarding the alleged greenwashing of their investment products are a good example. Such cases highlight blind spots in the market. Their root cause is an unclear definition of green economic activities. This, in turn, incentivizes investment intermediaries to arbitrarily define durable assets.

The rapidly changing sustainable financial markets are witnessing policy tools such as green classification systems called green taxonomies that provide a standard definition of green assets. These tools aim to increase financing for green projects, prevent greenwashing and help to better understand the extent of climate risks faced by various intermediaries in the financial sector.

The European Union (EU) and several countries, such as China, Malaysia, Mongolia and South Africa, have recently established their green taxonomies. The taxonomy of India is still at the draft stage.

As the biggest owners of financial assets in India, banks and insurance companies will be at the forefront of the effective implementation of the taxonomy in the country.

Banking industry perspective

With cumulative assets of US$2.5 trillion as of 2021, banks are the backbone of India’s financing. However, most of these assets do not meet India’s sustainability targets due to banks are not preparedability to manage climate and broader environmental, social and governance (ESG) risks. A green taxonomy would provide much-needed clarity. This would incentivize banks to set sustainability goals and align their business strategies with them.

Assessing exposure to sustainable versus unsustainable activities is difficult for banks without a taxonomy. Therefore, banks are not able to assess climate risk in their loan portfolio. A taxonomy would help banks assess the use of loan proceeds and the alignment of their loan portfolio with green activities. This will help disclose their portfolio alignment with the taxonomy, mitigate the risk of greenwashing, enhance their reputation and provide credible data points to the Reserve Bank of India (RBI) to determine climate risks in the entire banking system.

Additionally, disclosures based on the taxonomy should help expose the climate risks of non-green assets. Meanwhile, green businesses will benefit from better pricing due to lower risks and, potentially, reduced capital requirements. RBI, with a taxonomy as an important tool, can accelerate the discovery of climate risks in the banking system and direct credit towards sustainable activities. Once climate and sustainability risks are properly assessed, green or sustainable activities could attract bank loans on more favorable terms.

A taxonomy provides a common language for banks and their customers, improving engagement. To achieve their sustainability goals, banks can encourage their customers to adjust their activities. Banks will also play an important role in advising customers on available sustainable finance solutions and building the capacity to access them.

Insurance industry perspective

India is one of the most climate-vulnerable nations around the world. It also has a growing and diversified insurance market with assets under management (AUM) of 49 trillion rupees ($636 billion) in the financial year 2020-21.

National insurers have been weak in coverage climate-related lossesand their climate disclosures are among the worst in the world. As long-time risk managers, risk carriers and investors, insurers would benefit from a green classification system to identify assets with little contribution to climate risk. By doing so, they can promote stable investments in their portfolio and insurance underwriting practices.

On the liability side, without a green taxonomy, an unclear understanding of climate-aligned/affected economic activities can deter climate risk modeling and pricing in underwriting.

Insurers underwriting risks in fossil fuel-aligned sectors like thermal power generation may face a shortage of reinsurance cover from foreign firms. Indeed, insurers in jurisdictions such as the EU are increasingly reducing coverage of carbon-intensive sectors. Repricing of insurance products for these sectors in accordance with established emission thresholds for taxonomy-aligned activities would become important. In 2019, a 3x increase in energy project insurance cost annoyed domestic thermal power generation enterprises, which could happen more frequently.

On the asset side, there are two main issues related to climate change. First, the depreciation of asset values ​​due to physical and transition risks will lead to equity price shocks. Second, deteriorating borrower creditworthiness will cause bond prices to fall. India’s largest insurer, Life Insurance Corporation (LIC), holds 16% of its stakes in energy companies that are highly sensitive to transition risks. A green taxonomy will help insurers better understand the potential impact of individual investments on their portfolios.

As India moves towards energy transition, its financial institutions need a science-based green taxonomy to withstand the unintended consequences of climate risks. However, the central bank and the insurance industry regulator need to work together to successfully launch and implement a green taxonomy.

[This piece was authored exclusively for ETEnergyworld by Shantanu Srivastava, energy finance analyst and Saurabh Trivedi, research analyst, Institute for Energy Economics and Financial Analysis]


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Don F. Davis