Why it Pays Boards to Think Sustainably

Boards can no longer delay planning to transition to a low-carbon future given the increasing prudential risk, warns the Australian Prudential Regulatory Authority.

The weight of money

Investors, businesses and consumers are rapidly driving a transition to a low-carbon economy and institutions that don’t prepare jeopardising their future and that of customers, policy holders and members. That’s the blunt warning of APRA executive board member Geoff Summerhayes MAICD at a November 2017 Centre for Policy Development forum on Building a Sustainable Economy. A transition to a low-carbon economy was “underway and moving quickly.”

“The weight of money, pushed by commercial imperatives such as investment, innovation and reputational factors, is increasingly driving that shift, rather than scientists or policymakers,” he said. “Shifts in market sentiment have increased the risk of asset-value volatility and for the potential for stranded assets. Institutions that fail to adequately plan for this transition put their own futures in jeopardy, with subsequent consequences for their account holders, members or policyholders.”

Low-carbon investment

However, Summerhayes emphasised that climate change and adaptability is a story about opportunity as much as risk. “Businesses have much to gain from sensing the warming winds of change and moving ahead of the market and potential government or regulatory action.”

In November 2016, Australia ratified the Paris Climate Agreement, which has set up a binding (not presumably on the US, the one country that hasn’t signed the accord) global commitment to limit warming to between 1.5 and two degrees, and set a pathway for more ambitious emissions reductions efforts.

A recent report released at the UN Climate Change Conference (COP23) forecast investment opportunities of more than US$22 trillion in the years to 2030 to keep countries on track to meet commitments of the Paris Agreement’s target of limiting global warming to below two degrees. Summerhayes said that climate change and, crucially, society’s responses to it, was beginning to affect the global economy. Money was seeping from carbon-intensive assets and gaining volume in low-carbon investments.

“For example, the market for green bonds, for example, has grown from issuance of US$11b in 2013 to more than US$65b in 2017. Global employment in renewable energy increased to 9.8 million in 2016, with employment in fossil fuel extraction decreasing to 8.6 million according to the 2017 Lancet Countdown report.”

More regulation

Summerhayes warned that internationally, the trend is moving towards regulators taking a more interventionist approach. The UN and World Bank report recorded global growth in policy and regulatory measures targeting sustainability had grown 20 per cent year-on-year since 2010, but 30 per cent in the past year alone. “So whether due to regulatory action or, more likely, pressure from investors and consumers, Australia’s financial sector can expect more emphasis on disclosure around climate risk exposure and management.”

APRA takes action

A year on from his February 2017 landmark speech warning directors that climate-related financial risks were “foreseeable, material and actionable now”, APRA supervises institutions holding $6.1 trillion in assets for Australian depositors, policyholders and superannuation fund members. Summerhayes is flagging his concern at the level of prudential threat. He says the regulator has been improving its understanding of how the transition may impact individual entities, financial sectors and the broader economy. It has established an internal Climate Change Financial Risk Working Group to develop its supervisory response. The group is also developing a cross-industry heat map through the lens of Prudential Standard CPS220 Risk Management, identifying the key climate-related risks across each of the industries that it regulates.

APRA is asking insurers, superannuation funds and banks about their awareness of climate-change risks and what action may be required. It also plans to conduct an industry wide review of climate-related disclosure. It is also talking with Treasury, ASIC and the RBA, on sustainability and financial risk dimensions of the economy related to climate change — to improve information-sharing and understanding.

Impact on the bottom line

The Financial Stability Board Task Force on Climate-related Financial Disclosures (TCFD) recommends organisations use scenario analysis to model the impact of different assumptions about climate change and policy on their business.

The Centre for Policy Development recommended five principles to ensure that company’s scenario analysis is fit-for-purpose. Scenarios should:

• Be consistent with Paris targets, incorporating a high probability of limiting warming to below 2°C.
• Include both transition risks and physical impacts from climate change.
• Engage with the best available resources for understanding the sectoral or regional impacts of climate change.
• Be transparent about assumptions and parameters used.
• Show clear evidence, not just of analysis of climate risks, but of responses to them through strategy, governance and risk management.