Since Reserve Bank of India (RBI) published its discussion paper on climate risk for stakeholder consultation it is somewhat puzzling to notice that other financial regulators have not taken a similar approach to gauge the extent of climate risk in their respective domains. Climate risk, being a systemic risk, will impact the entire financial sector.
Let us take the case of pension funds. Globally, since the signing of UN Climate Change Conference (COP26), major pension funds such as the Ontario Teacher’s Pension Fund of Canada, the Danish ATP, APG of the Netherlands and pension funds in UK and the US are taking climate risk seriously. And why not—with roughly US$28trn (trillion) of assets, pension funds will be instrumental in financing the transition to net zero.
Extrapolating the global trends to India, climate risk has not featured in pension fund regulatory and development authority's (PFRDA’s) agenda, if we survey the recent annual reports.
Following the spirit of RBIs discussion paper, the logical question to ask will be: what the exposure of Indian pension funds to climate risk and what should be the approach going forward, given the answers to the first question.
The answer to the first question can be approached from different angles. But, to begin with, unlike banks, pension funds are somewhat different as they undertake consumption smoothing while banks undertake maturity transformation. Within pension funds themselves, another difference arises in the way consumption smoothing is organised, that is defined benefit (DB) or defined contribution (DC), and this mix differs across geographies.
In case of banks, the organisation is based on the principle of fractional banking which is universal. As a result, most soft standards that have evolved, such as the task force on climate-related financial disclosures, have focused on banks.
The primary motivation for pension fund to account for climate risk, in say strategic or tactical asset allocation, also differs depending upon the type of funds. For standard DB funds, climate risk influences both asset and liability side. Impact of climate change on mortality or asset returns will have a bearing on solvency of DB funds. Then, the idea of inter-generational equity, that is the bedrock of climate debate, is also applicable to DB funds.
In case of DC funds, which most of the Indian funds are, the primary concern is the impact on asset returns and contribution at risk due to climate-induced background risk. Background risk entails changes in wage growth or employment rate in climate sensitive sectors which are covered under one or another occupational pension plan.
The climate risk analysis of the Indian pension sector is also constrained by the topology of the sector with multiplicity of sponsors. If we separate the national pension scheme (NPS), the four other major funds; namely, the EPFO (employees provident fund organisation) and a long list of exempted funds under EPFO, Seamen’s Provident Fund by ministry of shipping, Coal Miners Provident Fund under ministry of coal and Assam Tea Plantation Provident Fund all have considerable background risk induced by climate change. With the exception of EPFO, the sector-specific climate risk will apply to the other three funds. We have still not touched gratuity funds and superannuation funds with life insurance companies.
Given this diversity, there is no unified data on entity-specific and geographical exposure of Indian pension fund assets. This makes assessment of physical and transition risk a challenging proposition. What best is available and published by RBI is thus used. The evolution of pension fund assets in flow of funds accounts since 2011 is shown below:
Clearly, three asset classes stand out: debt securities issued by financial corporations, Central government securities and state governed security or SDLs. The exposure to public and private non-financial corporations is to the tune of 5%. Thus, in a way, predominant exposure is sovereign in nature and climate risk is contained.
The exposure to financial corporations, which includes regulated entities of RBI, in the future will be decided by the stand taken by RBI after the stakeholder consultation. It may be worthwhile for PFRDA and other pension funds to submit a response to this discussion paper.
Now, climate risk management for pension funds involves assessing the carbon footprint of the investment portfolio. ‘Portfolio carbon footprinting’ is emerging as a standard tool for buy side institutional investors and an initial baseline is what we are concerned with.
Using some assumption and results from the
previous work and refining the instrument-wise flow of funds exposure to non-financial corporations, using data on sector-wise primary market issuances in corporate bonds market, a somewhat granular assessment of portfolio carbon footprint is possible. The carbon footprint of equity exposure is done using the S&P BSE ESG 100 Index (USD) fact sheet.
Clearly, pension funds in India are exposed to both physical and transition risk arising out of exposure to infrastructure debt. Contrary to our expectations, their financing of oil and gas is quite low. Their main cause of concern should be the exposure to RBI-regulated entities and transition risk therein.
In conclusion, we have traversed an uncharted territory and ended with some unique figures and perspectives in respect of climate risk of Indian pension funds. With no assurance on technology transfer or foreign funding promised to India under international agreements, Indian pension funds may be a source of financing path to net-zero. To begin with, proposed sovereign green bonds may be open for Indian pension funds. It is high time that respective sponsors and PFRDA take notice of this risk and make necessary adjustments as pension funds also perform the function of consumption smoothing across states (good times vs bad times).
(The author is an economist in the banking system. The views expressed here are personal)
