climate risk

The urgency factor has increased for boards on climate risk. Recent Australian developments have sharpened the need for government, policymakers and business to come to grips with the systemic risks climate change poses to the economy, strategy and governance. We summarise the main issues.

Climate change: what’s the risk?*

  • 33% of respondents consider climate-related financial risks as an immediate material risk 50% see them as a future material risk
  • Reputational damage, regulatory changes, flooding and cyclones are rated the top climate-related financial risks
  • Most banks consider climate-related financial risks part of their risk management frameworks
  • Less than 50% of life insurers and just over 50% of private health insurers are taking steps to improve their understanding of climate change risk

*2018 APRA survey

Economic impact

The Reserve Bank of Australia (RBA) has made its first detailed commentary on the economy and climate change. In a speech to the Centre for Policy Development on 12 March, RBA deputy governor Guy Debelle warned that both the physical impact of climate change and the transition required to contain climate change are likely to have first-order economic effects. He emphasised climate change is a trend change, not a cycle, and posed an unusual challenge. Unlike the cyclical or one-off shocks monetary policy usually faces — an acute shortage of bananas after Cyclone Yasi hit Far North Queensland in 2011, or the March closure of West Australian iron ore ports Port Dampier and Port Hedland in preparation for Cyclone Veronica — climate change was a permanent shift.

“The recent [Intergovernmental Panel on Climate Change] report documents that climate change is a trend rather than cyclical, which makes the assessment much more complicated,” said Debelle. “What if droughts are more frequent or cyclones happen more often? The supply shock is no longer temporary, but close to permanent. That situation is more challenging to assess and respond to. The transition path poses challenges, but it also presents opportunities. Particular industries and communities that are especially exposed to the costs of changes in the climate will face lower costs if there is an early and orderly transition. Others will bear greater costs from the transition to a lower carbon economy. While others, such as the renewables sector, may benefit from that transition… It may not be possible for the winners to compensate the losers in a way that leaves no-one worse off.” Challenges for financial stability — a core part of the Reserve Bank’s mandate — may arise from both physical and transition risks of climate change, said Debelle.

“For example, insurers may face large, unanticipated payouts because of climate change-related property damage and business losses. In some cases, businesses and households could lose access to insurance. Companies that generate significant pollution might face reputational damage or legal liability from their activities, and changes to regulation could cause previously valuable assets to become uneconomic. All of these consequences could precipitate sharp adjustments in asset prices, which would have consequences for financial stability. The transition path to a less carbon-intensive world is clearly quite different depending on whether it is managed as a gradual process or is abrupt. The trend changes aren’t likely to be smooth.”

APRA in action

On 20 March, the Australian Prudential Regulation Authority (APRA) released the results of its first climate risk survey of regulated entities, urging those entities to move from gaining awareness of the financial risks to taking action to mitigate against them.

APRA, which supervises entities with more than $6 trillion in assets, surveyed 38 large banks, insurers and superannuation trustees in late 2018 to assess their views and practices on managing the financial risks of climate change to their businesses. Its information paper, Climate Change: Awareness to Action, found a substantial majority of regulated entities were taking steps to increase their understanding of the threat, including all the banks, general insurers and superannuation trustees surveyed.

APRA said one third of respondents believed climate change was a material financial risk to their businesses now, and 50 per cent thought it would be in the future. The remaining respondents believed climate-related financial risks were not applicable to their business models — or they still had to undertake further analysis. Most banks responded that they considered climate-related financial risks part of their risk management frameworks.

Reputational damage, flooding, regulatory changes and cyclones were nominated as the top climate-related financial risks by survey respondents. Four of the seven authorised deposit-taking institutions (ADIs) surveyed ranked energy risk as their highest climate-related financial risk and most ranked transition and liability risks higher than physical risks.

The paper included a stocktake of initiatives in Australia and globally in response to growing awareness of the physical, transitional and liability risks of climate change.

APRA said a high level of awareness of climate change risks was shown across the ADI, general insurance and superannuation industries and institutions. However, fewer than 50 per cent of the life insurers and just over 50 per cent of private health insurers were taking steps to improve their understanding. Around one third of respondents indicated they have undertaken scenario analysis; 40 per cent said they were considering scenario analysis in the future.

If not, why not

Under Principle 7.4 of the fourth edition of the ASX Corporate Governance Principles and Recommendations, released in February, Australian-listed entities are encouraged to report on climate exposure on an “if not, why not basis” for financial years commencing on or after January 2020. The commentary to Principle 7.4 says one source of environmental risk relates to climate change. This includes both transition risks and physical risks such as changes in water availability, sourcing, and quality; food security; and extreme temperature changes affecting an organisation’s premises, operations, supply chains, transport needs and employee safety.

Listed entities are encouraged to consider whether they have a material exposure to climate change risk by reference to the recommendations of the TCFD and, if they do, consider making appropriate disclosures.

The Principles note that many listed entities will be exposed to climate risks even where they are not directly involved in mining or consuming fossil fuels.

APRA executive board member Geoff Summerhayes, also chair of the UN’s Sustainable Insurance Forum, said the challenge governments, regulators and financial institutions face in responding to the wide-ranging impacts of climate change “is to make sound decisions in the face of uncertainty about how these risks will play out”.

For businesses and financial markets, that challenge is understanding climate modelling and conducting the scenario analysis to determine the potential impact on their business and investments. Summerhayes said APRA’s views on the economic risks of climate change, echoed by the RBA, are consistent with those of financial regulators internationally. “These risks are material, foreseeable and actionable now,” said APRA. “Uncertainty over long-term impacts or policy direction is not an excuse for doing nothing.”

APRA confirmed many entities have moved from an initial phase of establishing a governance structure to strategically considering climate risks. It outlined how organisations had responded from risk management, governance and strategy perspectives.

Most ADIs surveyed said they included climate-related financial risks as part of their risk management framework, with the board having ultimate responsibility. Board committees and management groups assisted boards in overseeing the management of the risks. Some committees considered climate-related financial risks as part of their environmental, social and governance (ESG) activities and some organisations said they had set up specific climate risk working groups.

Many respondents noted that they had embedded climate-related financial risks into their enterprise risk management frameworks.

Those surveyed had implemented a number of strategic initiatives, including the development of climate change action plans, climate change position statements and roadmaps outlining strategy, targets and steps to reach their objectives. Some ADIs reported they were lending for green technology or introducing green bonds.

“Entities are considering climate change risks over multiple time periods, on short, medium and long-term horizons. However, some entities were focused on either short-term or long-term horizons only,” APRA noted. “These narrower perspectives may pose risks to those entities or leave the entities vulnerable to missed opportunities,” the report said.

Summerhayes said the world was rapidly transitioning to a low-carbon economy, driven principally by the decisions of governments, business leaders, investors and consumers. “Companies that fail to respond to these forces risk being left behind,” said Summerhayes. “Gaining an understanding of the risks is an important first step for entities, but APRA wants to see continuous improvement in how organisations disclose and manage these risks over coming years.”

Regulatory warning

Summerhayes said a barrier to action was the absence of an accepted global standard for identifying, assessing, comparing, and disclosing climate risks and opportunities. The closest effort yet, the recommendations of the UK Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), is supported by more than 500 companies with a combined market capitalisation of around US$8 trillion.

“As impressive as that sounds, it’s not enough… in the context of a global GDP estimated at US$88 trillion in 2018,” said Summerhayes.

“On that basis, regulators are increasingly questioning whether market-led action alone will produce an uptake in TCFD compliance at the scale and speed necessary to avert damaging financial consequences down the track.”