Pallavi: Welcome to the latest episode of the Sustaining Sustainability series by EY India Insights podcast, commemorating World Environment Day. I'm your host for today's insightful conversation. Today's topic focuses on "Funding Climate Resilience," where we delve into how the financial sector navigates climate issues, reducing risks, and embracing environmental opportunities. To facilitate the conversation further, we have Heena Khushalani, Partner, Climate Change and Sustainability Services, EY India. She's been a sustainability practitioner for more than 16 years and brings to us a wealth of experience across the US, South, and Southeast Asia. Heena is very passionate about driving sustainable development through the lens of catalytic finance. Heena, welcome to the podcast.
Heena Khushalani: Thank you. Thanks for having me.
Pallavi: Heena, to start off, I would like to ask how financial institutions assess the risks associated with climate change when considering investments or loans?
Heena Khushalani: Sure. So, the truth is that climate change, and specifically climate risk, has been a conversation that's been ongoing at global forums for almost more than a decade. Financial institutions at the global level have certainly been able to integrate climate risk into some of their decision-making processes. It's been a long road, and frankly, it's not perfect. But there has been a lot of practice. How much of that has translated to India? Frankly, India is at a very early stage at the moment when it comes to integrating climate risks while considering investments. I'll give you a quick layout of what climate risk means. There are two components to climate risk from an investment or a loan angle: one is the physical risk, and one is the transition risk. Physical risk is if I'm investing in a particular entity, that could be a project or a company. How much is that entity and their offices exposed to extreme weather, exposed to floods, earthquakes, and things like that because the climate and weather patterns are changing? Right? So how resilient is that company when it comes to physical risks?
Because the damages for a lender, like a bank, would be if that company loses some of their key assets due to climate risk, their ability to repay the loan payments is going to be limited. And hence, that's on the physical risk side. On the transition risk side, there are multiple different components: there's the technology risk, there's the regulation risk, there's the reputational risk, there's the customer preferences risk. So there's quite a bit. Transition risk is a much larger segment. Typically, what it means is that if I'm lending to a company that is in a sector like steel, steel as a sector is highly exposed. It's a hard-to-abate sector, which means its emissions are quite high. And with that being said, the sector is also exposed to a lot of risks when it comes to global regulations on climate change, like carbon tax, and the EU has impacted the steel sector in India already. But we're also talking about, specifically, the technology. So the companies here need to keep up with the technology and make it more energy-efficient so that they're able to compete globally when it comes to both pricing and technologies. So these are the two kinds of risks. And how do lenders look at it? There are multiple ways a bank or any financial institution can integrate climate risk. One, it's integrated into the traditional financial models, where they look at specifically looking at the adjusted returns and things like that. It's also integrated into the credit risk assessment. And again, credit risk is what I mentioned in terms of the ability of that party to be able to pay back. They also do regular stress testing, and that's what the RBI in India has come up with a regulation where banks and financial institutions need to do regular stress testing. It's not mandated yet; it's still in the draft stage. But we're hoping to get confirmation on this sometime in 2024, and post that regulation is when Indian banks are already starting to gear up to do regular stress testing in their portfolios to look at how much of their portfolio is exposed to the risk of climate risk. One is when you assess, and two is how you prepare to reduce your risk.
Right? And that's where they're going to have to start looking at, and banks start looking at every single loan that they're giving, in terms of what are the ESG risks that they're exposed to in some form, what is the company doing about it? Maybe, in some cases, they will take the ESG as a part of the key decision criteria. So to keep it very brief, I would say at the global level, we've definitely seen ESG risks and climate risk being integrated into decision-making, whether the loan should be given or not. In India, we haven't seen that fully translated yet, but it's just a matter of time because we are expecting regulations, and the banks will move faster.
Pallavi: Thank you, Heena, for those detailed insights. Now, what innovative financing solutions are being employed to support projects aimed at climate resilience?
Heena Khushalani: Sure. So, frankly, I want to first define what climate risk is and what we talk about when we say resilience. Right? So there are two components when it comes to climate risk: one is mitigation of the risk, and one is adaptation and resilience. Sometimes adaptation and resilience are kind of switched as words also in the investment community. On the mitigation side is where we see a lot of funding flowing already. And that's where the renewable energy infrastructure, the EV and mobility investments, some of these all fall under the mitigation category. And we've seen a certain amount of private and public capital going there. And that's kind of going well so far. But of course, there's a huge funding gap overall. But if we compare mitigation to adaptation, resilience mitigation is doing much better. Adaptation and resilience specifically. What does it mean? It means that specifically certain areas like, you know, how do we adapt ourselves to the new reality of the climate, which is the changing weather patterns? There are certain areas or certain sectors that will be more vulnerable compared to others. Right? So there are specifically three or four sectors. And we know agriculture as a sector is highly exposed to the risks of climate change. We know that health and biodiversity are also going to be exposed, as is disaster management.
So infrastructure financing also needs to take into account climate risks because these are all highly exposed. And how do these sectors or these areas adapt to climate change is what we're discussing right now, which is a component of the larger climate financing. So on the climate finance side, there's mitigation, and there's adaptation and resilience. Now that we've understood what adaptation and resilience are and which sectors specifically need a lot of funding and need support on this, there are multiple ways. So frankly, there are different ways of financing resilience. There are the traditional ways, which are the bonds, concessional debt to some extent, loans, equity. Now, climate resilience in some form is driven traditionally by the governments, which is the state and the central in India specifically. It's a part of the state mandate. But with that being said, there are a lot of other states which already have a budget deficit. And also, how do they finance climate resilience is a problem? And this is where we're starting to suggest, and globally, financial and climate resilience need to be funded with blended finance, which is there needs to be some innovation that's happening in some of these financing instruments. For example, there are outcome-based instruments, which are like sustainability-linked bonds, debt-for-nature swaps. Now, what does a debt-for-nature swap mean?
Basically, if at the sovereign level, so at the country level, there is a loan or the sovereign loan that country has, they will get a concession on it if a country is able to prove or achieve certain conservation outcomes or certain outcomes that are related to climate resilience. Very similarly, a sustainability-linked bond is for a company. So if a bank is funding a specific company and in that loan document or a bond, it can be sustainability-linked loans or bonds. And the bond is also where the fundraising is attached to certain KPIs, saying, "I will achieve, I will invest in energy efficiency. I will invest in climate risk resilience in all my plants and manufacturing sites. And if I'm able to do this, then I should get a certain amount of benefit from the financial institution."
And that's a sustainability-linked bond where a company gets some financial benefit for achieving these climate resilience targets. So this is where the outcome-based instruments come in. There is, of course, blended finance is a much larger term that's used across different kinds of instruments. I mean, there are catalytic investments like just simple risk guarantees. So this is again used mostly at the state and at the company level. A risk guarantee is one where specifically, a larger multilateral bank or some other larger institution risks a particular transaction saying, "You know what, if Bank XYZ is funding this company A, it's a very high-risk transaction. But there will be another, say, a company like ADB or any other multilateral development bank that will come and be the first loss guarantee in some form, saying that 'You know what, you go ahead and give the loan, and if there is a loss, then I'll be the first one to take that loss.' And I will. So the company, so the bank losses reduce."
So we need some of these very interesting, you know, and frankly, these are not very new ideas. The problem is they haven't scaled. And we really need parties to come together saying, "How about really piloting some of these instruments?" Some of them have happened at the global level. We need to pilot them in India because, you know, and not everything is directly translatable. I mean, we have to contextualize some of these instruments; some may be more successful, some may not be. You know, there's parametric insurance as well. There's so much that we can do specifically from an instrument, launching innovative financing. But we really need a forum in India where we are able to put this together and, and basically, pilot some of these instruments together. That's a quick brief on this one.
Pallavi: Thank you, Heena. In the previous question, could you also discuss some examples or case studies where funding has significantly contributed to enhancing climate resilience?
Heena Khushalani: Sure. So, the truth is, I mean, I have to say climate resilience is currently at an extremely nascent stage of funding. In fact, most actors who are currently working in the field would argue that there's barely any funding moving. I mean, the funding gap is huge. So to say that there's anything that's worked successfully is a bit difficult. I don't think there is any specific model that's been successful and scaled. Are there models? Yes. Like, for example, there are a lot of blue bonds and conservation bonds that are being raised by state governments and municipalities in different countries. There's one in Brazil that was launched a few years ago, and that's been going well. There's also, you know, in terms of the leading recent practices of what's working, there's something called the Asia Pacific Climate Finance Fund that's been supported by a multi-donor trust fund. It's being anchored by ADB. And specifically, what this kind of climate finance fund does is bring the funds from different agencies and be able to support everything from a sustainable insurance facility and supporting how a potential business model in insurance product design can happen. So what Aycliffe is doing, which is the Asia Pacific Climate finance facility, what it's specifically looking at is supporting the development of products to manage financial risks.
And that's where being able to work with different organizations in modeling new products, let that be on the banking side or let that be on the insurance side, is important. And we need more models like this, you know, and funds where different parties are able to come together and really pilot some of this, like I mentioned earlier. And at the same time, frankly, there is activity for sure. I have to say that I'm not, you know, but a lot of it currently is coming from the multilateral development banks like the World Bank, ADB, IFC. And so there's a little bit happening at the international level. In fact, some of the key gaps in India that we need to fill is certainly for the central and, you know, for the central ministry to be able to focus on adaptation funding as a key component because unless and until the government push is there, we won't be able to, frankly, scale any of this.
Pallavi: Thank you, Heena. Now pivoting towards the terms of policy and regulation, what changes are necessary to encourage more investment in climate-resilient infrastructure and technologies?
Heena Khushalani: Hmm. I would like to give this an India-specific take, you know, because that's the market that we're operating in right now. There are two key policy gaps in India that need to be filled. And the good thing is that the government has a strong focus. We all know that climate change is one of the key challenges that we are facing as we continue to grow as an economy. A lot of our growth can be stalled or, frankly, taken, like we're going to reverse our growth if we don't focus on climate change. And when we say don't focus, it's important both mitigation and adaptation and resilience. And there's a number I read somewhere that said India could lose 30 trillion in the next 25, 30 years if we don't focus on climate, you know, because of the impact of climate change. So the government has two key policies to take a look at, you know, to review in terms of supporting an increase in investments on the resilient side. And I'm talking about this both from the private investment angle as well as from the public investment angle. One is that, currently, like I mentioned, a lot of the climate resilience activity in India is anchored by the states. And the states don't necessarily one have the know-how to access the innovative financing instruments. Two, they don't have the funds available to anchor some of this work. And some of the states are definitely more vulnerable to climate change compared to others. Like Odisha, I think, is certainly one of the more vulnerable ones. But for them to be able to allocate a certain number of budgets towards climate adaptation and resilience will require support from the central Ministry of Finance.
You know, so that's where the Finance Commission in India, you know, when we're looking at the plans for the next five years, we certainly need to put a certain amount of focus on adaptation financing in the States and being able to support that. Blended finance is going to be, in some form, playing a key role when it comes to filling the climate finance gap. Let that be in India. Let that be globally. You know, I mean, India is looking to raise 10 trillion to fund the climate, you know, to achieve net zero by 2070. Now, there's absolutely no way India can achieve net zero without private finance being in the room. Right? And private finance, like I mentioned, there are a lot of challenges. And that's why private finance is not moving towards adaptation resilience. So what needs to be done for private finance to move towards climate adaptation and resilience? And that's where we need blended finance as the so basically private finance is saying that we would be willing to support, but we need somebody to reduce the risk for us. And that's with the, you know, a blended finance instrument and philanthropic capital in India can be leveraged. Now, there are certain laws, specifically the CSR law of India does not, you know, there's a lot of CSR funding that's, you know, every year, India is one of the only countries in the world that mandated corporate social responsibility and spend on it, you know, the 2% of the net profits every year. So there is a good amount of budget that's or rather funds philanthropic that are available to support blended finance in this area. But the laws and the policies don't allow companies to participate in impact or blended finance kind of transactions. So the policies need to change a little bit where the CSR funds can be utilized for blended finance, can be utilized for impact finance. And this will accelerate, you know, there's then there's a ready pool of capital that's available in some form to de-risk and to pilot some of these transactions. So these are the two areas that I believe we need policy changes in India.
Pallavi: Thank you, Heena. We did discuss the risks and, you know, the policy and regulation and the importance of blended finance. According to you, how does one balance the demand for immediate financial returns with the long-term goal of achieving sustainability and resilience in the face of climate change?
Heena Khushalani: So, frankly, there's no silver bullet here or there's no right or wrong answer. I think. I think it's, most importantly, the first step that we need to take is awareness. Awareness on climate change and climate finance. The importance of this across all stakeholders. I mean, unless and until a shareholder of the institution understands, they want the, you know, the pressure for on the companies to give the highest returns to the shareholders. That needs to be a bit more realistic. I mean, shareholders need to understand that, in some form, they will have to look at more of a long-term horizon instead of short-term returns. You know, I think, because the damage for a company from climate risk and climate change could also reduce the company's profits over a longer term. So hence there needs to be while I think education across all stakeholders, starting with shareholders, then investors and financiers, the companies and their executives, we need a certain amount of awareness and commitment across all stakeholders.
And that's only when we can balance, you know, the financial returns with long-term goals, or their policies. You know, there's a carrot-and-stick approach now. Policies can either incentivize companies that are looking at, you know, that are giving a good financial return, but with also managing the long-term risks. Or there's a stick approach if the companies are not adhering to managing the climate change and risks. And this will not be uniform, frankly, across, across the board this will probably be more I would say this has to be, a bit more stringent on companies that are operating in the hard-to-abate sectors or in the companies that have the highest exposure to climate risks. And those are the companies who will probably see a certain amount of pressure on them to, to manage the immediate financial returns. And that's precisely where even the shareholders of those companies will have to shareholders and financiers actually will have to understand about balancing the immediate short-term returns with long-term gains.
Pallavi: Thank you, Heena. That brings us to the end of today's episode. Thank you once again for joining us and sharing all your valuable insights. To all our listeners, join us next time as we continue to explore the confluence of sustainable practice and financial acumen here on the Sustaining Sustainability series. Don't forget to subscribe to our podcast across all our platforms for more discussions like this. Until next time, goodbye! This is Pallavi signing off.
