Climate-Related Financial Risk

Climate-related financial risk refers to the potential for climate change and the transition towards a low-carbon economy to adversely affect the stability, performance, and resilience of financial institutions and the broader economic system. In banking and finance, these risks influence credit quality, asset valuations, market stability, and long-term profitability. For the Indian economy, climate-related financial risk has become increasingly significant due to high exposure to climate hazards, dependence on climate-sensitive sectors, and the scale of financing required for sustainable development.

Concept and Classification of Climate-Related Financial Risk

Climate-related financial risks arise from the interaction between environmental changes and economic and financial systems. These risks are commonly classified into three interrelated categories: physical risks, transition risks, and liability risks.
Physical risks result from climate-related events and long-term environmental changes. Acute physical risks include floods, cyclones, heatwaves, and droughts, while chronic risks involve rising temperatures, changing rainfall patterns, and sea-level rise. These risks can damage assets, disrupt production, reduce incomes, and impair repayment capacity.
Transition risks stem from the process of adjusting to a low-carbon and climate-resilient economy. Policy interventions, regulatory changes, technological innovation, and shifts in consumer preferences can affect carbon-intensive industries, leading to asset revaluation, stranded assets, and changes in profitability.
Liability risks arise when firms or financial institutions face legal claims related to climate damages, inadequate disclosures, or failure to manage climate risks. Although still limited in India, liability risks are expected to grow with stronger environmental regulation and disclosure standards.

Climate-Related Financial Risk in Banking and Finance

In the banking sector, climate-related financial risks primarily manifest through credit risk, market risk, operational risk, and liquidity risk. Banks with significant exposure to climate-sensitive sectors such as agriculture, power generation, infrastructure, transport, real estate, and manufacturing face higher vulnerability to both physical and transition shocks.
Extreme weather events can directly affect borrowers’ cash flows and collateral values, increasing non-performing assets. Transition risks can lead to sudden changes in asset prices, particularly for fossil fuel–based industries, affecting banks’ loan books and investment portfolios. Climate risks may also disrupt banking operations through damage to physical infrastructure and information systems.
Financial markets are similarly exposed, as climate risks influence equity valuations, bond prices, insurance liabilities, and investor behaviour. Increased awareness of climate risks can trigger rapid portfolio reallocation, amplifying market volatility and systemic risk.

Significance for the Indian Economy

India is among the most climate-vulnerable economies globally, owing to its geographic diversity, long coastline, monsoon-dependent agriculture, and high population density. Climate-related disasters impose recurring economic costs, affecting productivity, employment, and public finances. These impacts transmit to the financial system through reduced credit demand, higher default rates, and increased fiscal pressures.
The Indian growth model relies heavily on infrastructure investment, urban development, and energy consumption. While these sectors drive economic expansion, they are also exposed to climate risks. Financing carbon-intensive activities increases exposure to transition risk, particularly as India advances its climate commitments under the Paris Agreement.
Regional disparities further complicate climate-related financial risk in India, as climate impacts vary significantly across states and districts. This spatial concentration of risk has implications for regional banking networks and public sector financial institutions.

Role of the Reserve Bank of India and Financial Regulators

The Reserve Bank of India has increasingly recognised climate-related risks as a potential source of systemic financial instability. The RBI has taken steps to integrate climate considerations into its regulatory and supervisory approach, including promoting climate risk awareness, encouraging improved disclosures, and supporting capacity-building within financial institutions.
Indian regulators are also engaging with global initiatives such as the Network for Greening the Financial System, which provides analytical frameworks and best practices for managing climate-related financial risks. These efforts aim to enhance consistency, comparability, and forward-looking risk assessment in the Indian financial system.

Transmission Channels of Climate-Related Financial Risk

Climate-related financial risks are transmitted through multiple channels. Physical risks affect real economic activity, leading to lower output and incomes, which in turn increase credit risk. Transition risks influence asset prices and investment decisions, affecting market stability and capital flows. Fiscal channels are also important, as increased public spending on disaster relief and adaptation can affect sovereign risk and crowd out private investment.
In India, the close link between banks, non-banking financial companies, and public sector enterprises can amplify these transmission mechanisms, increasing the potential for systemic effects.

Implications for Financial Institutions and Policy

Understanding climate-related financial risk is essential for effective risk management and strategic planning. Banks and financial institutions are increasingly expected to integrate climate considerations into governance structures, credit appraisal, portfolio management, and internal controls. This includes adopting climate risk assessments, scenario analysis, and stress testing frameworks.
From a policy perspective, addressing climate-related financial risk supports financial stability and facilitates the mobilisation of capital towards sustainable and resilient economic activities. It also helps avoid abrupt market corrections and disorderly transitions that could undermine growth and development objectives.