It is now accepted by the scientific community that climate change is caused by a rise in global temperatures, in turn caused by Greenhouse gases (GHG) emissions resulting from anthropogenic activities such as burning fossil fuels, releasing of gases in industrial processes, among others.

When we discuss Sustainability and ESG, and, as COP (Committee of Parties) meetings go, the Paris meeting of 2015, COP21 is a landmark meeting where 196 nations came to grips with the subject and laid targets for bringing down the global temperatures. It was recognised that unless climate change was controlled, it would lead to frequent and severe droughts, heatwaves, heavy unseasonal rainfall etc.

The three scopes

First conceptualised by the GHG Protocol (accounting and reporting standards for businesses and governments) to find a way to account for emissions of gases, its study has now been universally accepted when reporting on Sustainability and ESG and the categorisation of emissions into three Scopes.

Scope 1 emissions occur from sources that are owned or controlled by an entity, Scope 2 emissions are from the generation of purchased electricity and energy consumed and Scope 3 emissions are a consequence of the activities of an entity and occur during the operations of the value chain partners including vendors manufacturing inputs for the entity.

Within Scope 3, GHG Protocol has identified eight upstream activities and seven downstream activities. One should refer to the GHG Protocol publication ‘Corporate Value Chain (Scope 3) Accounting and Reporting Standard’ for understanding the Scopes.

Of late, one downstream activity listed in Scope 3 viz., ‘Investments’, also referred to as ‘financed emissions’ has been gaining significant interest. Investments are also an entity’s activity which can cause emissions. By an extension, loans given by banks and other entities such as NBFCs being funnelled into investments come under this category.

‘Financed emissions’

Reserve Bank of India has been encouraging ‘Regulated Entities (REs)’ including commercial banks, NBFCs coming under its purview to address these issues lately and to disclose the financial implications of risks faced by REs. Among RBI’s publications, there are two that must be taken note of. These documents draw heavily from the report issued by the Task Force for Climate-related Financial Disclosures (TCFD). They are:

(1) Discussion Paper on Climate Risk and Sustainable Finance; dated July 27, 2022; and

(2) Draft Disclosure Framework on Climate-related Financial Risks, 2024 dated February 28, 2024.

The fundamental premise is that climate changes will cause severe disruption to businesses and damage to the assets of borrower-enterprises and will affect their ability to fulfil their commitments to the lenders, leading the lenders themselves to absorb those losses ultimately.

Physical risks

As articulated by RBI, climate change can impact the financial sector through two broad channels — physical risks and transition risks. Physical risks such as floods, heatwaves, landslides wildfires etc., can impact expected cash flows of REs from exposure to these physical risks, and also can cause damage to the assets held as security against loans thus impairing the ability of the borrowers to service the loans,

There is also the possibility of damage to own assets of the REs.

Transition Risks

The transition risks are those that are caused by a break in supply chains as a result of prohibition of certain materials in manufacture. There have been some instances in the past when materials such as asbestos and certain refrigerant gases were banned requiring shift to other materials.

Newer technologies conforming to emissions norms may require time to invent affecting businesses and may require fresh investments which may be beyond the ability of the entities already indebted to the banks and NBFCs. Even customers may request REs to direct their deposits and investments into more climate-friendly policies.

As the RBI notes, on account of the increased threat of climate change and the associated effects on entities, it is imperative for the REs to implement climate-related financial risk management policies .

Accordingly, RBI has now proposed disclosures required at a minimum detailed in Annex 1 to the Draft Disclosure. Initially, the guidelines are proposed to be applicable to Scheduled Commercial Banks and Top and Upper layer NBFCs from the financial year 2025-26 onwards in matters of Governance, Strategy and Risk Management and from 2026-27 for Metrics and Targets.

Admittedly, Scope 3 disclosures are the most difficult to comply with since the information is not with the entities concerned and it is not always easy to calculate the emissions. For its part, following the Monetary Policy Committee’s meeting on October 9, 2024, RBI is now proposing to form a Climate Risk Information System which will serve as a databank/source relating to local climate scenarios, climate forecasts and emissions to help REs.

PCAF is an industry-led initiative started in the Netherlands in 2015 by some leading Dutch financial institutions (FIs). Of late, PCAF has been gaining significant attention for being considered an acceptable guidance for calculation of emissions in the financial sector.

As it states in its acknowledgements, PCAF enables the FIs worldwide to consistently measure the GHG emissions caused by their financial activities. Per ‘PCAF (2022), The Global GHG Accounting and Reporting Standard Part A: Financed Emissions. Second Edition’, detailed methodological guidance has been provided for the following asset classes:

(1) Listed equity and corporate bonds, (2) Business loans and unlisted equity, (3) Project finance, (4) Commercial real estate, (5) Mortgages, (6) Motor vehicle loans., and (7) Sovereign debt.

Of the seven categories, except for the sovereign debt, the methodology adopted has been reviewed and approved by GHG Protocol. It is learnt that commercial banks in India have already started engaging with large borrowers on the above lines.

The writer is a Chartered Accountant