New guidance on managing climate risks 11 min read
Recently released guidance from the Australian Prudential Regulation Authority (APRA) and two new barrister opinions re-emphasise the need for banks, superannuation trustees, insurers, and other organisations, to respond to, and appropriately manage, financial risks associated with climate change.
We examine the impact of these recent developments and outline the key actions to consider.
- How APRA-regulated entities should manage the financial risks associated with climate change (ie climate risk) has been the subject of three recent developments:
- APRA has released draft cross-industry prudential guidance CPG 229 Climate Change Financial Risks (CPG);
- Noel Hutley SC and Sebastian Hartford Davis released a further supplementary legal opinion on company directors' duties and climate change; and
- Noel Hutley SC and James Mack released an updated legal opinion on superannuation trustees' duties and climate change.
- These documents emphasise the importance of APRA-regulated entities (including banks, superannuation trustees and insurers):
- considering how the three pillars of climate risk (physical risks, transition risks and liability risks) apply in the context of their business;
- ensuring that any representation of a 'net zero' commitment (or similar) is founded on a reasonable basis (or else risk exposure to member complaints and/or regulatory action);
- ensuring that adequate risk management and governance frameworks are in place to identify, understand, manage and mitigate climate risks;
- considering the adoption of the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), particularly in relation to scenario analysis and useful disclosures for stakeholders.
As a reminder, it is widely accepted that the types of financial risks associated with climate change (ie climate risks) can be grouped into three broad pillars:
- physical risk (including risks of direct damage to assets or property, changes to income or costs such as insurance);
- transition risk (being the risks of financial costs associated with the transition to a low-carbon economy); and
- litigation or liability risk (such as risks of litigation or regulatory enforcement).
These risk pillars form the foundation for the ever-brightening spotlight on risk management, governance and disclosure of climate risks.
The three recent developments bolster expectations as to how APRA-regulated entities (including banks, superannuation trustees and insurers) should approach the management of the financial risks arising from climate change.
1. APRA's draft CPG 229 Climate Change Financial Risks
APRA released its draft cross-industry CPG on climate change financial risks for consultation on 24 April 2021. It is accepting feedback until 31 July 2021, and the CPG is expected to be finalised before the end of the year.
The overarching message in APRA's draft CPG is that organisations need to take a strategic and risk-based approach to the management of climate risks. Notably, however, the draft CPG does not impose specific new requirements on APRA-regulated entities — rather, it aims to aid compliance with APRA's existing risk management and governance prudential standards. 1
In particular, the CPG indicates that APRA considers that:
- better practice in the management of climate risks would involve the identification and measurement of such risks and their potential impacts, qualitative and quantitative monitoring, documented management and mitigation plans, and established reporting structures for information on material climate risk exposures to be regularly reported to the board and senior management;
- a prudent board would (among other things) ensure climate risk is understood and discussed at board and committee level, and consider climate risks and opportunities both periodically and when approving strategic and business plans (with a short- and long-term view);
- certain functions could appropriately be delegated to senior management (subject to monitoring by the board) — eg senior management could be responsible for utilising an entity's risk management framework to assess, monitor and manage climate risks, reviewing its effectiveness (and revising as needed), making recommendations on climate risks and opportunities to the board, and ensuring appropriate resourcing (including capacity training of senior staff) to manage such risks in the business; and
- a prudent entity would consider making (and continually evolving its practices in terms of) voluntary disclosures on its approach to managing climate risks beyond statutory or regulatory requirements, where there is a need for entities with international activities to be prepared to comply with mandatory climate risk disclosures in other jurisdictions. APRA considers the TCFD recommendations (which are emerging as the market standard)2 to be a 'sound basis' for producing useful information for stakeholders.
The draft CPG also draws on aspects of the TCFD recommendations as an example of 'useful guidance on conducting scenario selection and analysis to assess the impacts of climate risks'. It emphasises APRA's expectation that its regulated entities undertake climate risk scenario analysis and stress testing, with a view that leading practice entails:
- a short-term assessment of the entity's current exposures to climate risks (in line with current business planning cycles); and
- a long-term assessment of the entity's future exposures to climate risk based on multi-factorial scenarios considering the rise of future temperatures (eg in excess of 4˚C by 2100 or 2˚C or less) or economic transition pathways (eg an orderly or disorderly transition to a lower-emissions economy).
APRA recommends that scenario analysis for short- and long-term assessments should also (among other things):
- incorporate the use of quantitative and qualitative factors (if available) into scenarios used to project future financial conditions;
- assess both physical and transition risks within each scenario (see the three risk pillars above);
- involve consulting with external experts (eg climate change academics or relevant scientific bodies); and
- consider future trends in catastrophe modelling, technology innovation or policy development.
2. New opinion on company directors' duties and climate change
Noel Hutley SC and Sebastian Hartford Davis released a legal opinion on climate change and directors' duties dated 23 April 2021 (which supplements their earlier opinions on these issues).
The opinion posits that company directors' standard of care for climate change has risen since 2016 and continues to rise. Notably, the opinion also foreshadows that 'greenwashing' as to companies' net zero emissions commitments could be the focus of a 'third wave' of climate change litigation. That is, Hutley and Hartford Davis emphasise the market trend of 'pressure to commit to net zero' emissions by 2050 and the liability risks associated with a net zero commitment — eg claims relating to misleading and deceptive conduct if such a commitment to a future representation is made without a reasonable basis at the present time and could therefore be inaccurate.
In light of this, the opinion recommends that companies and directors take practical steps to manage the liability risks associated with net zero commitments (including ensuring there is a reasonable basis for making the commitment) and increase the likelihood of available defences in the event they are swept up by the anticipated 'third wave' of litigation.
3. New opinion on superannuation trustee duties
Noel Hutley SC and James Mack released a supplementary opinion on superannuation trustee duties and climate change dated 16 February 2021 (which follows an earlier opinion published in 2017). In brief, the opinion emphasises that superannuation trustees need to thoroughly understand the degree and nature of climate risks, and take steps to manage those risks in the same way that a trustee would manage any other financial risk (including to seek information from investment managers to assess manager capability to manage risks relating to investments on behalf of the trustee). These actions are considered necessary by Hutley and Mack in order for a trustee to satisfy its covenants in the Superannuation Industry Supervision Act 1993 (Cth), such as to act with the same degree of care, skill and diligence of a prudent trustee and in members' best (financial) interests, and APRA Prudential Standard SPS 530 Investment Governance (among other legislative and prudential requirements).
In particular, the opinion encourages trustees to consider the requirements in SPS 530 from the perspective of climate risks — eg to consider how climate risks are relevant to investment selection and diversification as part of a fund or investment option's broader investment strategy (and even consider divestment if the climate risks of an investment are too great for a particular investment option), and undertake scenario analysis to aid an understanding of climate risks relating to investments.
Consistent with ASIC and APRA's statements on climate risk, the opinion also warns that trustees should expect regulators to exercise their enforcement powers in relation to their practices in addressing climate risk, and therefore prepare accordingly (ie seek expert advice, ensure there is sufficient internal expertise to understand that advice, and take action to manage and mitigate climate risks).
The three recent developments provide a clear reminder of the need for APRA-regulated entities to consider and take active steps to manage climate risks. These may include:
- documenting evidence of the management of climate risks within risk management policies and procedures (reviewed on an ongoing basis), and ensuring that there are robust senior management and board reporting structures. This ties in with existing obligations under APRA prudential standards relating to risk management and governance, and will necessitate a clear description of the respective roles and responsibilities in relation to managing climate risks;
- enhancing climate risk monitoring capabilities, including both qualitative and quantitative approaches to scenario analysis and stress testing (noting that APRA expects that APRA-regulated entities to take an approach proportionate to their size, business mix and complexity, and points out these are developing areas that will continue to evolve over time); and
- assessing disclosure obligations and/or whether voluntary reports should be made using one of the best practice frameworks (such as the TCFD recommendations noted above).
We expand further below on the implications for specific sectors.
From a banking perspective, APRA notes climate risks can impact a bank's lending and credit risk across retail and business loan portfolios. It points out that this may materialise through a potential increase in defaults on loans by businesses and households that may be affected by adverse climate events, as well as the potential for loss associated with the declined value of assets used as security.
Separately, banks are increasingly scrutinised for their investment in climate change-related projects, which can increase exposure to reputational risk.
Banks should also:
- consider the 'greenwashing' warnings, given that 43 of the world's largest banks recently made a collective pledge to align their lending and investment portfolios to net zero emissions by 2050;3 and
- note APRA's intention to undertake a climate change financial risk vulnerability assessment beginning with the larger banks sometime this year (although the design process is still in progress). This assessment may be applied to other APRA-regulated entities in future, including insurers and superannuation trustees. We will be closely monitoring this space for any developments.
To the extent it was really required post-McVeigh v REST, the developments reinforce that there is a need for trustees and directors to proactively consider climate risks through the lens of the financial best interests of members, having regard to trustee and directors' duties. What this means in practice will ultimately depend on the particular fund and investments but, generally speaking, trustees should embed climate risk assessment in investment processes (to the extent it is not already), focus on ensuring their climate-related disclosures are appropriate, and remain aware of climate change litigation risk and the ways in which this can be managed.
Climate risks relevant to operating a fund could include risks relating to liquidity, reputation, operations and market. These should be identified and managed at both at the aggregate level of investments and the asset level. That is, trustees should consider factoring in climate change risks, like any financial risk, in selecting and reviewing overarching asset allocation and investment strategy, and particular investments and managers.
Trustees should also ensure that appropriate obligations are passed on to investment managers and investee entities. This could involve:
- setting up a formal reporting process, such as KPIs imposed on managers that include climate-related targets and allow the trustee to assess the performance of its managers against those KPIs on a periodic basis;
- passing through relevant duties and obligations on climate-related risk management controls to managers — eg to ensure that investment managers are appropriately considering climate risks in their decisions;
- ensuring the trustee can obtain information it needs from managers to implement its investment strategy and make climate-related disclosures; and
- ensuring its managers actively consider climate change resolutions of investee companies and that the trustee retains the ultimate power to decide on voting positions.
Underwriting risk is the immediate concern that is front of mind for insurers. APRA notes this in the draft CPG, emphasising the need for them to consider how underwriting risk will impact the management of the financial risks of climate change — eg there may be a potential increase in insured losses as a result of more frequent and/or extreme weather events.
APRA explains in its draft CPG that, due to the unprecedented nature of climate change, historical data and the traditional backward-looking risk assessment methods that typically underpin the insurance industry may be an inadequate means to anticipate future impacts. Therefore, insurers will need to be cognisant of the risk of relying on historical data when revising policies or recalibrating risk models.
See APRA Prudential Standards CPS 220 Risk Management, SPS 220 Risk Management (SPS 220), CPS 510 Governance, SPS 510 Governance (SPS 510) as applicable.
See our previous Insight on the TCFD recommendations.