[Commentary] RBI’s report envisions India’s low-carbon economy of the future

India’s goal of achieving net zero emissions by 2070 raises important questions for policymakers regarding potential risks to the financial system and necessary policy reforms. These concerns are particularly relevant for macroeconomists who need to understand how the relationship between monetary and fiscal policies will evolve in this context.

The RBI’s Currency and Finance Report for 2022-23 ‘Towards a Greener Cleaner India’ traces India’s journey towards achieving its Nationally Determined Contributions (NDCs) and explores all policy changes that will be instrumental in shaping India’s net-zero economy. The report discusses a myriad of issues relevant to transition, such as electric vehicle penetration, hydrogen adoption, state-level initiatives, and developments in financial markets.

The low-carbon transition entails a fundamental economic shift. Thus, it is expected that there will be output and price effects. RBI’s work on macroeconomic projections holds currency. Therefore, the report contributes to the current discussions not just by providing long-horizon forecasts but also by comparing what the nationally determined contribution and net-zero targets imply for growth and inflation.

The report builds three scenarios for energy transition- One, where an annual trend growth rate of 6.6%, adhering to nationally determined contribution would require doubling the rate of reduction in energy intensity as well as renewables forming a share of primary energy consumption at 70% to achieve net zero by 2070. Two, where India is to achieve the status of the advanced economy (AE) by 2047, that would require an annual GDP growth rate of 9.6% which would raise the net GHG emissions 10.5 times from the levels of 2021-22. Three, where the country is to achieve the twin objectives of reduction in energy intensity and AE status, it would require an even more ambitious scaling up of RE in the primary energy consumption mix (82% by 2070) and a 5.4% increase in reduction in energy intensity annually.

Net zero by 2050 is the most promising scenario

The projections show that net zero by 2050 is the most promising scenario, as it leads to the least loss of output. Unfortunately, the NDCs mimic the status quo trajectory as the economic setback. The report mentions “the divergent net zero and delayed transition scenarios cause a larger negative impact on GDP on account of temporal and sectoral imbalances in impact realisation and transmission.”

Inflationary effects are also expected to play out on account of physical and transition risks. Continuing, as usual, is expected to raise inflation on account of the physical risks. However, under more ambitious scenarios, the efforts to mitigate will result in inflationary pressures that would emanate from a carbon tax and other mitigation efforts that raise the cost of production. The report refers to the International Monetary Fund (IMF) ‘s work proposing carbon taxes of $25 and $50, which are efficient in reducing emissions under different scenarios. However, how these are built into the projections and will impact inflation or consumption is not quite clear.

It is widely accepted that a carbon tax can be strategically ideal, not just for nudging domestic shifts but also given that advanced economies are mulling border adjustment taxes. Yet, carbon taxes also raise equity concerns. While the output effects are factored in, it remains unknown from the analyses how this would affect households. Though the report lists how a carbon tax can be used to support a redistribution mechanism through recycling revenues either by providing incentives to corporates or transfers to households, there is no evidence of how this will, in turn, impact the estimates in the report.

The varying impact of transition

Transitioning to a low-carbon economy will not uniformly affect sectors and will require a sector-based approach. Like, sectors that consume fossil fuels as inputs will have to reimagine their processes. While the forecasts provide a macro-picture, the vision for how exactly these risks percolate through sectors in the fossil fuel value chain is not evident. The report mentions the importance of a shift in production to less energy-intensive sectors-fisheries, textiles, land transport, and services an option. While these are alternatives to consider, these sectors are not high in the value chain and confront other sector-specific challenges. For example, the textile industry has been grappling with a paucity of skilled workers and concerns about pollution. Diversification therefore would need to be thought through in the context of trade and employment implications. For this, a new or green industrial policy- not within the remit of the central bank’s mandate- that reimagines the structure and composition of GDP aligned with net zero is necessary.

The financial sector is exposed to assets in the fossil fuel-based sectors. It is important to acknowledge such risks to manage the transition better. Today, most models that foresee risk are within the limit of 30 years or immediate. However, RBI’s report goes beyond this horizon to measure risks. RBI’s risk modelling shows that a one-time climate shock to capital will immediately reduce output by 0.5% and 1% up to five quarters, reducing incomes and consumption. The analysis is insightful as it reveals what may be future impacts of climate change on the financial sector and can help nudge change in investment behaviour.

As far as current loan exposures of the banking sector are concerned, there are three relevant features that can affect the transmission of risk from transition. One, the public-sector banks remain more prone to climate-related risks as well as capital shortfalls. Two, green sectors have been a part of priority lending, but there are signs that not all such lending is sustainable and viable. The share of green sectors in industry gross non-performing assets (GNPAs) has increased. Third, public sector banks across states have higher exposure to the power sector, whereas the private sector reports a higher share of transport operators. Moreover, these loans remain spatially concentrated across states. Therefore, the transition pathway will have a different impact across the banking system, and the source of financial stress within the green industries needs early identification.

Given the prevalence of these risks, a relevant aspect is if banks are prepared to address climate risks. RBI has surveyed banks and reports that most are cognisant of the risks of the transition. Banks are also aware of mining, automobiles, agriculture, infrastructure, and construction sectors where risks are pronounced. However, the lack of data and capacity seems to be a challenge to climate risk assessment and mitigation.

RBI identifies key action points for the central bank. These include disclosure of climate risks, differential reserve requirements to green credit, margin facility for sovereign green bonds (SGBs) as well as the use of Central Bank Digital Currency (CBDC).

The report is an interesting review of climate action and policy. However, it places importance on policies outside the RBI’s mandate. The report underscores that the success of the transition hangs on the development of taxonomy as well as hinges on the availability of appropriate technology. At the same time, policy actions such as taxation, spending, and budgeting will be critical. While the report marks a step forward by the RBI, it also highlights miles to go until net zero.

Suranjali Tandon is an Associate Professor at the National Institute of Public Finance and Policy.

Banner image: Lack of data and capacity seems to be a challenge to climate risk assessment and mitigation. Photo by Manish Kumar/Mongabay.