A notable feature of the Reserve Bank of India’s (RBI’s) latest Monetary Policy Report (included in its April Bulletin) is the primacy given to “extreme weather events” and “climate shocks” affecting not only food inflation but also likely having a broader impact on the natural rate of interest, thereby influencing the economy’s financial stability. Natural, or neutral, rate of interest refers to the central bank’s monetary policy lever, which allows it to maintain maximum economic output, while keeping a check on inflation. The report mentions a “New-Keynesian model that incorporates a physical climate risk damage function” being used to estimate the “counterfactual macroeconomic impact of climate change vis-à-vis a no climate change scenario”. The report’s authors go on to warn that the “long-term (economic) output” could be lower by around 9% by 2050 in the absence of any climate mitigation policies. They ominously add that ‘if inflation hysteresis gets entrenched, it may lead to a de-anchoring of inflation expectations, and the undermining of the central bank’s credibility would warrant higher interest rates to curb inflation, leading to greater output loss’.

Beginning with its July 2022 discussion paper on ‘climate risk and sustainable finance’, the RBI has made incremental progress to address the transition to a green economy, even while admitting that India requires over $17 trillion to achieve its net zero ambitions by 2070. Its peers in advanced economies, most notably the European Central Bank, have aided the formulation of a green taxonomy for the entire Eurozone’s economic value chain. A green taxonomy is a framework to assess the sustainability credentials and possible ranking of an economic activity. The RBI and the Finance Ministry could take inspiration from the developing world, especially the ASEAN region, where a layered green taxonomy as a living document keeps getting updated with sectoral views of possible sustainable trajectories. While the issuance of ₹16,000 crore worth of Sovereign Green Bonds and expanding the resource pool by allowing Foreign Institutional Investors to participate in future green government securities are welcome steps, the RBI must undertake a thorough-going assessment on the quantitative and qualitative impact on economic and financial stability due to climate change. It must encourage administrative consultation to begin populating a layered green taxonomy that is reflective of India’s fragmented developmental trajectories. The effort should be to mitigate the transitional risks to the financial system as the economy moves towards a sustainable future.