Nishant Sharma and Saurav Thampan

The best time to act on climate change was decades ago, the next best time is now. Recently, acknowledging the financial impacts of climate change on investments, global financial institutions have formulated specific metrics for their due diligence that are set to have far reaching consequences on the capital raising capability of businesses and projects across the world. This article analyses the impact of these metrics on Indian businesses and suggests reforms in the legal taxonomy of green securities available in the Indian capital markets which are in sync with these financial institutions’ concerns and, therefore, help Indian businesses ride this climate wave with lesser damage.

Introduction

Economic damage from climate change-related natural disasters, such as hurricanes, wildfires or heat waves, has risen sharply in the past 40 years. Between 2016 and 2018, climate change-related weather events caused more than $630 billion in losses worldwide. In addition to these events, there are evidences of financial and environment regulatory bodies increasing (or planning to increase) the regulations to align their action with the commitments under the multilateral climate conventions, such as limiting the global warming to 2 degree Celsius above the pre-industrial levels.

Climate change and its associated threats have been in the books of investors for long; although any action towards this cause has been more from a philanthropic and ‘ESG approval’ perspective rather than considering climate change as an actual financial threat to their investments. The first deliberations on this began with the launch of the Equator Principles in Washington D.C. in 2003 which broadly covered social and environmental factors that needed to be taken into account by financial institutions in project finance. Fast forward to 2020, it has released its latest edition – “EP4”, which discusses the direct and immediate financial effects that climate change poses to these financial institutions.

Global financial institutions such as Morgan Stanley, Goldman Sachs and UBS Investment have also come up with their own climate metrics that help them differentiate down to individual businesses and projects that will be able to withstand the policy risks and physicals risks that climate changes poses in the near future. These metrics have the potential to limit the access of Indian businesses to financial resources even in the absence of any stringent regulations in the Indian capital markets.

The Metrics and their Impact on Indian Businesses

The risks that climate change poses to a business can be either direct or indirect in its effect; or acute or chronic in its impact. The Financial Stability Board’s Task Force on Climate-Related Financial Disclosure (TCFD) considers climate change’s impacts from two angles: one, transition risk, which encompasses the policy and legal, technology, market and reputational changes to organizations stemming from the transition to a low-carbon economy, and; two, physical risk, which refers to extreme weather or geological events such as hurricanes, floods and the like, or changes in climate patterns and sea levels which happen over time.

Morgan Stanley Institute for Sustainable Investing recently came up with a three dimensional approach to assess the climate risks comprehensively. This allows the investors to differentiate the more risk-averse locations and sectors from the ones that are risk-perverse. More importantly, it also helps them narrow their investments down to those specific corporations, businesses and projects that are relatively safer as compared to the entire risk spectrum of locations and sectors.

The three dimensional approach defines climate related risk in terms of:

1. Events – which are the natural or human induced incidents, either or acute or chronic, that may have adverse effects on vulnerable and exposed people, communities, businesses or investments;
2. Exposure – constitutes the factors that determine a company’s level of risk in terms of a climate-related event, such as its business activities in specific geographies or under certain legal jurisdictions; and
3. Vulnerability – are the underlying weaknesses that can exacerbate the level of risk to those specific entities that have such weaknesses.

Let us take India’s Renewable Purchase Obligations (RPO) provided for under Section 86(1)(e) of the Electricity Act 2003 and the National Tariff Policy 2006 as an example of the transition risk. It provides that certain “high energy consuming industries” need to procure a certain percentage of their energy requirements from renewable sources. Alternatively, the companies which are unable to fulfil a certain percentage of their energy requirements from renewable sources can also purchase Renewable Energy Certificates (REC) on the Indian Energy Exchange in lieu of their required renewable energy requirements. This means that the companies who primarily obtain their energy requirements from non-green sources have to pay for these RECs in addition to having to pay for their entire energy requirement. For instance, company A used coal for 100% of its energy requirements, whereas it was required of it to use green energy for 30% of its energy needs. Now, company A will be required to purchase RECs amounting to what would have been the cost of renewable energy for 30% of its needs. To top this, coal cess has gone up by 800% in the past few years. In this example, the RPO policy and the increase in coal cess are the events arising out of acute transition risk from the policy/legal sector. The factor that a certain business finds itself under the “high energy consuming industry tag” is the exposure it faces. The vulnerability, therefore, is how much energy each business consumes from non-renewable energy sources. Vulnerability is a crucial differentiating factor for investors because it will help them differentiate between those businesses that have comparable levels of exposure to same events. In effect, within the same high energy consuming industry, investors are significantly less like to make future investments in businesses that are largely dependent on non-renewable resources because of the REC and coal cess costs associated with them. Alternatively, it can be said that the investors are much likely to invest in businesses that either have their own green energy plants or purchaser their energy from green energy sources, given the present and future policies favouring the renewable energy sector.

To also approach this issue from the point of physical risk events, let us consider the drought that India faced last year. Around 42% of India’s land area had to face drought, which was four times the drought that India had to face the year before. Karnataka, Maharashtra, Telangana and Tamil Nadu were among the states that suffered the worst. The lack of availability of water affects the businesses that need farm produce from these areas, the construction and project companies that need water for their activities, and even the technological companies such as TCS and Infosys which are least expected to be affected by such climate-related events. Majority of the operations and workforce for these tech businesses are situated in Mumbai, Chennai, Hyderabad, Bangalore, and Kolkata, all of which either fall in the areas of above mentioned draught struck states, or experience greater severity of  cyclones every year owing to their coastal zones. In this case, this draught becomes the chronic physical event. The fact that these businesses were located in the geographies which suffered from draught is the exposure. The vulnerability will be decided based on how many of these have alternate means of getting water for their business requirements (and this might be a major problem for SMSEs since they are less likely to be able to arrange multiple resource channels).

These changes are clear indicators that the investors are now interested in jurisdictions that have stable and comprehensive climate change action plans in place, and more specifically in those particular businesses that are well-equipped to handle these changes. Resultantly, investors are likely to become vary of investing in Indian businesses if they find that a majority of them are unable to satisfy the metrics. The primary solution to this could be to organize the capital markets in such a manner that they facilitate inflow of capital for those businesses that require it to adapt to climatic changes, whether physical or policy. If this is done keeping in mind the renewed approach, investments could be attracted in the longer run as well as investors would be comfortable in investing in businesses that have accommodated their concerns.

Concluding Suggestions

The first and crucial step in making the Indian capital markets more facilitative for green finance or climate finance would be to develop a comprehensive taxonomy for “green” assets, “sustainable” projects and like terms that are currently interchangeably and quite flexibly used. The current SEBI disclosure requirements for green bonds and securities are very vague on their classification of what “green” is; and this issue has been pointed out by many time and again. The SEBI vide their circular in 2017 (Circular) identified all those projects which fall under certain broad categories such as renewable and clean energy, clean transportation, sustainable waste management etc., however, this still remains vague in its operation and could possibly used for green washing the investors. More importantly, this classification fails to cover those businesses that may not be focusing their operations in the sustainable development industry, but would nonetheless require investments in the future at a time when investors would be increasingly scrutinising their options based on how green those businesses are.

The European Union and China have come up with their own definitions which are more inclusive as well as specific than what India has come up with. These definitions to some extent do include those businesses as well in the scope of financing which may not entirely be falling under the class of sustainable sectors; however, even they fail to account for the specific metrics discussed above that the financial institutions now utilise for deciding whether a business is worth investing.

Therefore there are two essential concerns that India needs to accommodate: one, a definition that is wide enough to accommodate all businesses; and two, a definition that is capable of accommodating the new metrics such that the investors do not have a fear of being “green-washed” by investing in India’s green or climate securities that have been vaguely defined. The best approach to cover these businesses that form a very substantial part of our economy would be to base the definition of green on very specific indicators that the international investors now use for classifying a business as “green”, such as:

1. Total Carbon Emissions – a measure of total carbon emissions from a company’s activities;
2. Carbon Intensity – a measure of carbon emissions using revenue to account for differences in company size. It allows for comparison across holdings and portfolios of different sizes, distinct from absolute emissions;
3. Emission Reduction Targets – a baseline indicator for whether a company has made a public commitment to reduce its emissions. It may also include evaluation of any plans and strategies in this regard;
4. Carbon Earnings at Risk – a measure for the estimated present value of future earnings loss based on a company’s current emissions and the projected price path of carbon emissions, determined based on the required energy mix to achieve a given global warming scenario. Most relevant to determine cost of transition risk rather than physical risk; and
5. Climate Change Revenues – a measure for the current revenue tied to products and services mapped to activities addressing (or aggravating) the root causes of climate change. It is also influenced by the strength of the link between underlying products and services and climate change impacts.

These are largely comprehensive in determining the impact of all and any business on the environment and the climate. These are forward looking, point-in-time as well as backward looking in their approach. They not only judge the harmful impacts, but also taken into account the company’s approach towards harm mitigation. Furthermore, they propose to also include the environmental impact of the suppliers’ activities and impact from the end-use of their product or service into account.

A proper taxonomy and classification will only act as a gateway into the Indian capital markets. For actual inflow of capital, the regulators and lawmakers will need to come up with attractive and creative investment instruments that enable both the investors and the domestic businesses to take advantage of.

In 2019, India became the second-largest market globally for green bonds with $10.3 billion worth of transactions. Nonetheless, there has been no green bond issuance yet by either the Central or state governments. Since the definition of these green bonds is limited to specific sectors, a considerable number of businesses have not been able to take advantage of the green bonds and a substantial chunk of the market is still not capitalised upon. Moreover, the vague terminology used by the Circular hints that a large chunk of these green bond issues might just be “green-washing” the investors and the businesses issuing this will ultimately fail the comprehensive metrics discussed above when finally put to test in the near future.

Less than a year ago, India proposed the Draft Environment Impact Assessment Notification (2020) which significantly reduces the environment responsibilities and liabilities of the project proponents while getting environmental clearance for a project in India; however, after receiving mass criticism from the public, was not implemented. This was done to lure more project proponents into the country, however with changes in investment behaviour as discussed above; it becomes doubtful as to whether such projects once accepted will be able to raise the capital from institutional investors that they usually require. Infact, a vague and unclear approach to climate change regulation and green finance from the government might just further discourage the investors.

Nishant Sharma and Saurav Thampan are fourth-year students at the National Law University (NLU), Jodhpur.