Insurers, banks and superannuation funds face liability risk for failing to disclose, address and manage the effects of climate change.
The Reserve Bank of Australia (RBA) is calling on financial market participants to “act now” to manage the financial risks of climate change, given the implications for financial stability.
“Climate change can significantly affect the prices of assets if it reduces future cash flows and makes them more volatile,” RBA Head of Domestic Markets Jonathan Kearns said on 24 August.
Climate risks affect the value of assets used as security for loans, the incomes borrowers rely upon to make repayments, and therefore the potential losses that lenders face, he said. “If financial entities mismanage their climate risks, they are also exposed to liability risk.”
Compared to insurers, banks have less experience modelling the financial impacts of climate events, and “more work” is needed to develop their management of these financial risks. “Not only do they need to develop the systems and procedures to manage these risks, but they need to start by collecting and analysing the right data,” Kearns said.
The effects of climate change on multi-year mortgages and business loans are “likely to be significant but are also very uncertain”. For instance, climate change can reduce the value of property backing a loan, or make insurance on property untenable – which can exacerbate loan losses.
Meanwhile, superannuation and managed funds – while seeking to maximise the return for investors – face difficulties assessing the sensitivity of returns on particular investments to climate change, given the inconsistent and incomplete information available.
“While super funds don’t operate as direct channels of financial stability risks from climate change, they could become indirect channels if they were to contribute to rapid price falls through large sales,” Kearns said.
He also warned of the threat of liability risk, which all insurers, banks and super fund trustees face if they do not disclose, address and manage the effects of climate change sufficiently for their customers and owners. “Ensuring they provide detailed information on their exposure to climate risk is important in managing liability risk.”
Kearns noted that Australian regulators, through the Council of Financial Regulators (CFR), created a Climate Working Group back in 2017, and have since been seeking to ensure firms produce and disclose high-quality and consistent information about climate-related risks, and that they carefully manage those risks.
The CFR Climate Working Group identified three priority areas over the past year: the Climate Vulnerability Assessment (CVA), disclosures, and taxonomies and sustainable finance.
The CVA is a climate scenario analysis being conducted by the five largest banks under guidance from APRA Australian Prudential Regulation Authority (APRA), taking into account anticipated physical and transition risks through to 2050. It seeks to assess the potential exposure banks have to climate risk, understand how banks are likely to adjust their business models in response to those risks, and foster an improvement in banks’ management of climate risks.
The banks used scenarios developed by the Network for Greening the Financial System to assess the implications of climate risk for their credit risk models and the structure of their balance sheets. In late May 2022, the results were provided to APRA, which is looking to publish information on the outcomes and insights later this year, Kearns said.
The CVA exercise should help to facilitate the development of high-quality and comparable climate-related disclosures, which are “important to allow investors and counterparties to have confidence in how firms are managing their climate-related financial risks”.
On taxonomies, Kearns emphasised the need for widely recognised and utilised definitions for what is considered ‘green’ or ‘sustainable’, to increase the quality and consistency of information available to financial market participants and contribute to improved management of climate risks.
The development of an Australian taxonomy is a key priority for the Australian Sustainable Finance Initiative (ASFI). Kearns said the CFR agencies are supportive of this work and have joined the ASFI’s Technical Advisory Group as observers.
“Climate change can have a significant impact on the structure of the economy, and the pricing and return on assets,” he said. “This means climate change has implications for the efficiency and stability of the financial system.”
“These are complex issues and our understanding of how best to respond will evolve over time. But it is critical that financial market participants and regulators act now to best manage the financial risks and facilitate the associated opportunities.”