The need for a green lending taxonomy

India has committed to achieving net-zero emissions by 2070, a pledge made under the Paris Agreement.

While the spotlight often falls on changes in the energy infrastructure and the manufacturing sector, the banking industry is crucial in pioneering the transition to a greener economy.

As global environmental standards are tightened, Indian banks must align with sustainability to remain competitive and support India’s larger environmental goals.

Banks are the backbone of any economy, determining which projects receive financial backing. Their decisions can either accelerate sustainable development or continue financing activities that lead to high emissions and pollution.

With depositors becoming more conscious of environmental issues, there is growing public pressure on banks to avoid fuelling projects that harm the planet - either fossil fuels or polluting companies.

Recognising this shift, the Reserve Bank of India (RBI) formed a Sustainable Finance Group, guiding banks toward lending and investment practices that protect the environment.

Green banking involves channelling funds toward projects that help protect the planet. This includes financing renewable energy, encouraging energy efficiency and refraining from
supporting industries that harm natural resources.

However, evaluating the true environmental impact of any project is a complex process. Companies sometimes use greenwashing, exaggerating their eco-friendly claims while concealing the ongoing environmental damage. An example is a solar panel manufacturer that contributes to lowering carbon emissions but pollutes water bodies, creating a net negative impact.

The German asset management firm DWS, a subsidiary of Deutsche Bank, a systemic bank, recently provided an example of greenwashing. In 2020, they initially classified 549 billion euros as ESG compliant, but revised that figure to 115 billion euros in 2021 following the enactment of stricter European Union guidelines. This discrepancy led to fines and changes in leadership, pointing to the reputational and financial risks tied to overstated sustainability claims.

In response to these challenges, the European Commission developed a sustainable finance taxonomy, requiring companies to show how their activities contribute to key environmental goals, such as reducing emissions, safeguarding water resources, or shifting to a circular economy without undermining other objectives. By introducing consistent reporting and clear standards, this framework makes it easier for investors and banks to identify genuine green projects.

India’s banking sector stands to benefit significantly from adopting a green finance taxonomy. Following the six objectives of the European Union — climate change mitigation, climate change adaptation, sustainable use and protection of water resources, transition to a circular economy, pollution prevention and control and protection of biodiversity — would help Indian banks to fund genuinely eco-friendly projects.

For any economic activity undertaken by a European company, it has to report how it is making a significant contribution to any of the goals while not harming any of the other goals. For example, a factory manufacturing solar plants contributes to climate change mitigation. However, if it uses fossil fuels, it contributes to harming the environment.

The company would report the impact of its project in a comprehensive manner, allowing lenders to assess the project’s environmental impact.

Using such an approach would align with India’s plans to expand renewable energy. Recent NPCIL directions seek investments in small nuclear plants, as nuclear plants offer an alternative electricity source to solar plants after sunset.

The current understanding in sustainability circles is that small nuclear plants are less polluting than coal plants, and business leaders such as Bill Gates have been investing in these natrium plants. Small nuclear plants offer a good alternative source during the early evening electricity demand.

During early evenings, solar power would not be available and home battery power is insufficient for operating energy-guzzling microwaves or washing machines; nuclear power can compensate for this lack. A green taxonomy would place the investments in such nuclear plants on par with solar plants, and banks would easily extend loans under green or brownfield lending. 

Similarly, banks could precisely categorise drought-resistant agriculture and coastal afforestation as green loans. Banks could also prioritise water management by financing household rainwater harvesting systems in cities and municipal wastewater treatment plants.

Banks could provide loans for waste-to-energy projects and biodegradable packaging, a key to reducing dependency on single-use plastics. Pollution prevention efforts, such as installing emissions control devices in factories or promoting electric vehicles, would also receive targeted financing.

Finally, banks could support biodiversity protection by funding ecotourism projects or reforestation projects while screening out extractive projects in climate-sensitive regions such as the Western Ghats.

Banks currently face challenges in assessing the “green” environmental impact of projects. A taxonomy would allow for an objective risk assessment and capital allocation.

Therefore, the RBI and other policymakers’ agenda would be to develop a green taxonomy for the Indian economy that is focused on corporate activity.

Developing a green taxonomy would provide a uniform classification that would eliminate ambiguity between different banks, and all endings would be aligned with India’s long-term environmental goals.

Policymakers can examine recent corporate investments and bank lending practices to develop an India-specific green taxonomy rather than adapt a foreign methodology.

Furthermore, the RBI could demand compliance reports with climate-related lending reports from all scheduled banks and PSL lending information. For banks and the RBI, lending based on a transparent green lending taxonomy would leave no scope for greenwashing or misrepresented lending practices.

This taxonomy would also benefit corporates as ESG funds (which in the past have struggled to find the right investments) decide to invest in Indian companies with transparent green projects. This could be a win-win situation for all stakeholders.

(Meera is professor in accounting, economics and finance, and Reddy is assistant professor in marketing, T A Pai Management Institute, Manipal)