Climate Risks and Monetary Policy: India's Economic Balancing Act

Over the past two years, India’s agricultural output shrank as a result of severe heat waves during the March-April period (ICAR, 2024). An analysis by the Council on Energy, Environment, and Water (CEEW) estimates that each 1-degree Celsius increase in temperature, combined with higher atmospheric carbon dioxide concentrations, results in a fall in rice and wheat production by 4% to 20% respectively (Chaturvedi, 2015). 

 An analysis by the Council on Energy, Environment, and Water (CEEW) estimates that each 1-degree Celsius increase in temperature, combined with higher atmospheric carbon dioxide concentrations, results in a fall in rice and wheat production by 4% to 20% respectively

Immediate policy actions face criticism, for instance, the promotion of issuance of Sovereign Green Bonds has been criticised on account of transparency and accountability of the funds raised. How despite these challenges, a vast economy like India can achieve its long-term developmental goals remains unanswered. On the face of it, we have hardly altered our economic growth and development paths for the sake of intergenerational equity and sustainability.

Amidst the ongoing discussion of incorporating a climate change mitigation model in the monetary policy framework, the agriculture sector and inflation expectations of the masses clearly demonstrate the severity of the situation. Like any other commodity, food prices in the market are determined by the interactions of demand and supply. Indian agricultural production, particularly in the Northern regions, depends on spring snowmelt to replenish water supplies. The output from the primary sector decides the level of food secutiry India can enjoy in the coming years. It has been predicted that earlier snowmelt on account of climate change can substantially reduce the water table during the sowing season thereby impacting production (Sharma et al., 2022). Additionally, the southwest monsoon is necessary for agriculture as it brings about 80% of rainfall in the country (Aijaz, 2013).

Unfortunately, the assessment of environmental damage is still absent from the traditional models used by central banks for policy analysis and forecasting to address the rising concerns of climate related shocks and trends. Without climate mitigation policies and high climate risks, India's long-term output is projected to decrease by 9% by 2050 compared to a scenario with no climate change, where economic performance is not impacted by physical risks like extreme weather conditions (Reserve Bank of India, 2023). Thus, climate related economic uncertainties are likely to undermine the effectiveness of monetary policy tools, such as interest rate adjustments. Lower productivity and output due to rising temperatures and extreme weather conditions reduce the natural rate of interest. This lower natural interest rate, in turn, curtails the central bank’s ability to set further policy rates to effectively manage economic activity.

The Reserve Bank of India is responsible for financial and macroeconomic stability. Through its regulatory grasp on money, credit, and the financial system, RBI supports the development of green banking models. Green central banking refers to a central banking mechanism that considers ecological and climate change risks which may have a significant impact on the financial sector's short- and long-term stability, and the macroeconomy in general. Through this a clear distinction is outlined between the canonical functions of economic and financial stability performed by central banks and their responses to environmental externalities. Green central banking, thus, bridges the gap by ensuring central banks devise climate change mitigation policies while simultaneously incorporating them into monetary policy designs.

The existing literature on green central banking primarily focuses on three key dimensions viz. de jure factors, dealing with the legal constraints; de facto constraints, involving cases of practical implementation; and central bank signalling, conveyed through the communication channel of the central bank. These dimensions illustrate the willingness of central banks to incorporate climate related risks in their monetary policy tools. However, these factors drive policymakers into a defensive stance, impeding them from taking a proactive approach. Subsequently, India needs to strike a balance between economic growth and environmental sustainability, aiming for a low-carbon and climate-resilient future. India's Green House Gas (GHG) emissions have roughly doubled since the turn of the century, with the country now emitting approximately four billion metric tons of carbon dioxide equivalent per year (Statista, 2024). For the RBI to take a participative role in sustainably transforming the economy, an explicit legal mandate is needed to pursue its greening objectives.