Australian guidance aims to support financial firms with climate risk

Out-Law Analysis | 11 May 2021 | 9:16 am | 3 min. read

The Australian Prudential Regulation Authority’s (APRA) draft guidance on managing the financial risks of climate change confirms an increased focus by authorities and regulated entities in this area.

The APRA released a consultation on its draft Prudential Performance Guide (PPG) on Climate Change Financial Risks (19 page / 874KB PDF) in late April.

The guidance sets out APRA's views on sound practice in areas of governance, risk management, scenario analysis and disclosure. It does not impose new requirements in relation to climate risks, but instead it is aimed at assisting and supporting supervised institutions in managing climate risks as a part of their governance and risk management frameworks.

The guidance is aimed at banks, insurers and superannuation trustees and is aligned with the recommendations from the Financial Stability Board's Task Force on Climate-related Financial Disclosures (TCFD).

Financial risks of climate change

The APRA classified climate change financial risks into three categories. Physical risks relate to changing climate conditions and extreme weather events, the consequences of which may lead to lower asset values, defaults on loans and increased insurance claims.

Transition risks include changes in domestic and international policy, technological innovation, social adaptation and market changes, which can change costs structure, income and profits and investment preferences and asset viability. The resulting disruption from adjustment to a low-carbon economy may result in stranded assets and supply chain disruption.

The third category is liability risks, which can give rise to potential litigations if institutions and boards are considered to have failed to adequately consider or respond to the impact of climate change.

Supervised institutions are also advised to consider potential impacts on credit risk, market risk, operational risk, underwriting risk, liquidity risk and reputational risk and adapt relevant risk management policies accordingly.

Governance

A regulated institution's board, or, in the case of a foreign bank or insurer, the senior officer outside Australia or compliance committee, is responsible for overseeing and managing climate risks, according to the APRA proposals. The board is expected to ensure the firm has an appropriate understanding of climate risk and set clear roles and responsibilities of senior management in the management of climate risks.

The guidance suggests a board should also re-evaluate the risks, opportunities and accountability arising from climate change on a periodic basis, and consider these risks and opportunities in approving the institution's strategies and business plans. Boards should take both short and long-term views when assessing the impact of climate risks and opportunities, and ensure the firm’s risk appetite framework incorporates the risk exposure limits and thresholds for the financial risks that it is willing to bear.

Risk management

APRA said it was prudent practice for a firm to provide evidence of the management of climate risks within its written risk management policies, management information, and board risk reports. The risk management framework should address the respective roles and responsibilities of business lines and risk functions.

It is expected that an institution will be able to demonstrate how it determines the materiality of climate risk within each of the identified categories of risk within its risk management framework.

The guideline suggests that prudent firms will seek to identify economic sectors with higher or lower exposures to physical or transition climate risks as a step towards developing sector-specific policies and procedures for the institution when undertaking business engagement.

In terms of risk monitoring, the APRA said firms should ensure that climate risk data and metrics are updated regularly to support decision making by the board and senior management. Better monitoring also extends to monitoring the impacts that climate risks may have on outsourcing arrangements, service providers, supply chains and business continuity planning.

Regulated institutions are also expected to establish and implement plans to mitigate material climate risks and manage its exposures. For example, an institution might develop plans to manage concentrations in its portfolio to certain geographic or economic sectors with higher climate risks, such as transitioning from fossil fuels to renewable energy.

APRA said providing finance to assist customers to adapt to climate change was an important function of the financial system.

Finally, APRA expects that a prudent institution would establish procedures to routinely provide relevant information on its material climate risk exposures, including monitoring and mitigation actions, to the board and senior management. This would assist the board and senior management in making decisions consistent with the institution's overall risk appetite and risk management approach.

The consultation is open until 31 July and the final PPG is expected to be released before the end of 2021.