APRA guidance on managing climate change financial risks finalised for banks, insurers and superannuation trustees

By Geoff Sanders, Katerina Karavatis
APRA Financial Services

Setting the tone for how regulated institutions should approach climate change risks 6 min read

Delivering as promised before the end of 2021, APRA recently finalised its prudential practice guide CPG 229 Climate Change Financial Risks.

What does this mean for you?

Following consultation on its draft guidance earlier this year (see our Insight: Key developments for APRA-regulated entities in managing climate risks), APRA's finalised CPG 229 outlines its non-binding guidance in relation to climate change financial risk management in order to assist all APRA-regulated institutions (including banks, superannuation trustees and insurers) to comply with existing APRA prudential standards relating to risk management and governance.

While prudential guidance does not introduce new legal obligations, APRA's CPG 229 sets the tone for how it expects its regulated institutions to approach climate change risks. Arguably, it may not differ too greatly from setting obligations in an era of an increasing focus on climate change risks and increasing regulatory scrutiny. That said, APRA has still sought to maintain a principles-based approach to the finalised guidance that should be considered, in its words, 'in the context of [an institution's] particular risk profile and business model' with a recognition that 'not all aspects…will be relevant to all institutions'.

What's changed in the final prudential practice guide?

The finalised guidance is largely similar to its draft, which is no surprise given the almost 50 broadly supportive submissions made by industry on the draft guidance. While APRA's Response Paper dated 26 November 2021 indicates a number of suggestions for additional guidance (including some going so far as asking APRA to include reference to social considerations), APRA seems to have taken a relatively light touch approach to implementing the suggestions in the finalised guidance.

The key changes from the draft guidance are summarised as follows:

Encouragement to set climate-related targets

APRA has included new guidance in the final CPG 229 that prudent institutions may wish to set climate-related targets for their activities to help manage climate risks and opportunities. It specifies that these targets should be linked to an institution’s climate-related metrics and aligned to its overall business strategy and risk management framework. Further, these targets may also reference external benchmarks such as sector, national and/or international targets. The Financial Stability Board’s Taskforce for Climate-related Financial Disclosures (TCFD) recommendations are referenced for further guidance.

Don't delay scenario analysis

APRA's guidance indicates a view that developing (or accessing) capabilities in climate risk scenario analysis and stress testing would be prudent in order to fulfill obligations under applicable prudential standards relating to risk management. In particular, APRA's final CPG 229 specifically notes that the expectation of future improvements in the approach to scenario analysis 'is not a justification for delaying its use'. While the message here is clear that APRA would like institutions to give scenario analysis a go now, APRA's Response Paper includes a slightly softer encouragement for institutions to determine and follow their own approach and timeframes for implementation.

Disclose key design features of scenario analysis

Where scenario analysis or stress testing results are disclosed, APRA has included new guidance in the final CPG 229 that significant design features and decisions necessary for stakeholders to effectively interpret (and compare) the results should also be disclosed. APRA has also: (1) specified that its expectation of documentation of the method and results of scenario analysis would include 'an assessment of the limitations of the analysis for assessing the climate risks faced by the institution' and (2) clarified considerations for building scenarios relating to future temperature rises to better align to the Paris Agreement objective of limiting global average temperature increases to well below 2°C by 2100 and current understanding of future climate trajectories.

Recognition that there may be different ways to document the impact of climate change financial risk on capital adequacy

APRA has reframed its guidance on capital adequacy to express its view more broadly that it is appropriate for an institution to consider and record any material impact on capital adequacy as a result of climate risks. APRA's final CPG 229, applying generally to all of its regulated institutions, provides that an institution may choose to use the Internal Capital Adequacy Assessment Process (ICAAP) for this purpose (even if not required to do so) to record material exposures and how the assessment of those exposures is considered, eg within stress testing policies and processes.

Stronger support for TCFD recommendations – but no mandate

APRA has reframed its view that the TCFD recommendations (which, as we have previously said, are emerging as the market standard) are 'a sound basis' for producing useful information for stakeholders to more strongly provide in the final CPG 229 that it is 'better practice for any disclosures to be produced in line with' the TCFD recommendations. However, APRA has made clear that mandating climate risk disclosure falls beyond the scope of CPG 229 and any proposal to introduce such disclosure requirements would be subject to consultation before introduction.

Additional factors to assess climate risk exposure

APRA considers that a prudent institution would seek to identify the exposure of economic sectors to physical and/or transition climate risks. In the final CPG 229, APRA has bolstered its list of risk criteria for this identification to include vulnerability to climate-related disruption of supply chains and/or business activities (in addition to factors such as vulnerability to extreme weather events, level of greenhouse gas emissions etc).

Lastly and while not technically in the final CPG 229, APRA's Response Paper describes that feedback was sought on how climate change financial risks should be considered by superannuation trustees in the context of the 'Your Future, Your Super' reforms (including the new best financial interests duty and performance test). In stating generally that superannuation trustees must comply with the best financial interests duty and sole purpose test when making investment decisions, APRA also clarified its expectation of how climate change financial risk ties in with these obligations. Notably, APRA's expectation is that trustees 'will take climate change financial risk into account in the same way as other risks they consider, with the ultimate objectives unchanged: considering whether the proposed investment is ultimately in the best financial interests of members, is consistent with the RSE licensee’s investment governance framework and aligns with a properly formulated investment strategy or strategies, including the relevant risk and return objectives.' While there are arguably no surprises in this, it is helpful to have APRA's expectations so clearly set out in a way that seems to go further than existing investment governance guidance for superannuation trustees.

What's next?

Looking ahead, APRA intends to undertake a survey next year to help gauge the alignment between institutions' management of climate change financial risks, APRA's finalised guidance and the TCFD recommendations.

APRA-regulated institutions may also want to keep an eye on matters raised in consultation that APRA has said it will continue to monitor but did not include in the final CPG 229 – eg in light of some submissions suggesting there should be a connection between climate change financial risks performance objectives and remuneration incorporated into CPG 229 (so as to provide clear incentives), APRA noted it will continue to monitor international developments in this regard. That said, APRA retains its view that boards should maintain the discretion to design a remuneration framework that is appropriate for their institution.

Specific to superannuation trustees, APRA also indicated it would consider feedback on alignment between the final CPG 229 and its superannuation prudential standards and guidance relating to investment governance (SPS 530 and SPG 530) as part of its proposed enhancements to that material. Consultation on APRA's proposed amendments to SPS 530 closes in February 2022 (with enhancements proposed to commence on 1 January 2023).