Regulated entities (REs) should address financial risks arising from climate change and environmental degradation, through its risk management framework, in line with Board-approved risk appetite statement, risk management strategy and business plan, said the RBI
Mumbai:
The Reserve Bank of India(RBI) has released today a “Discussion Paper on Climate Risk and Sustainable Finance’’ outlining broad guidance for all regulated entities (Re) to have appropriate governance, strategy to address climate change risks and risk management structure to effectively manage them from a micro-prudential perspective.
REs should address financial risks arising from climate change and environmental degradation, through its risk management framework, in line with Board-approved risk appetite statement, risk management strategy and business plan, said the RBI.
According the discussion paper, REs may integrate a climate-risk assessment as part of their due diligence process. This climate-risk assessment not only includes physical and transitional risks the customer is exposed to but also how these risks may materialise into any reputational risks for the RE.
The assessment may result in a climate-risk rating for customers having material exposure to such risks. High risk ratings may be periodically monitored to assess the climate-related risks for the RE. REs should integrate climate-related and environmental risk in their risk management framework in a consistent and systematic manner.
They may need to put in place robust policies and processes which would include a clear articulation of roles and responsibilities of business lines and risk functions in accordance with the three lines of defence model.
The first line of defence is provided by business line staff, who may assess climate and environmental risk before accepting new business and throughout the ongoing management of business relationships, particularly for sectors with higher climate-related and environmental risk.
The second line of defence provided by the risk management function may monitor the implementation of the bank’s climate risk management policies by business lines. The third line of defence provided by the internal audit function may conduct independent review and evaluate the robustness of the bank’s risk management framework in managing climate-related and environmental risk.
REs may develop a comprehensive methodology to identify risks arising from environmental and climate change and its effect on their business models. The identification and assessment of climate-related and environmental risk may be done at a customer, sector and portfolio level.
They may also incorporate the customer’s exposures to transition risk in its assessment. The scope and extent of this assessment may be attuned to factors including the sector, customer’s operations, and nature and size of the transaction.
The effectiveness and resilience of REs in navigating climate-related and environment risk needs to be supported through proper formulation, planning and implementation of climate and environment strategy, and embedding climate and environment considerations within the organization. REs may determine impact of climate-related and environmental risk on their business strategy in the short, medium and long-term, said the RBI.
The financial risk emanating from climate and environmental degradation would have to be assessed and addressed within the overall business strategy and risk appetite. The risk appetite framework of REs could include the risk exposure limits and thresholds of financial risks that the RE is willing to take.
While formulating the risk appetite framework, the Board would need to ensure that it considers the factors like the long-term financial interest of the RE, results of stress testing and scenario analysis.
Senior management may ensure that adequate resources with appropriate expertise are allocated through capacity building and training, to implement climate strategy. REs may also need to ensure that the organizational structure and business processes are reviewed to support effective communication and co-ordination among different businesses and operation units.
REs could also identify, measure, monitor, manage, and report the exposure related to climate-related and environmental risk in a manner proportionate to the size, complexity of its business operations and risk profile.
Some climate-related risks may also materialise beyond a bank’s traditional two-to-three-year capital planning horizon but within the maturities of longer-dated exposures. Other climate-related risks may materialise over a much longer time horizon.
The high degree of uncertainty around the timing of these risks suggests that REs may take a prudent and dynamic approach towards developing their risk management capacities.