Financial Resilience in the face of Climate Related Risks

Executive Summary

Australia was lit a flame during the Black Summer period of 2019-2020 where the country experienced its most severe bushfire season in over 25 years, and most severe economically on record. The burning platform has sent a call to action in Australia when it comes to climate resilience and the financial risks it poses to Australia’s economy.

This dossier succinctly explores the global macro-prudential regulatory response to climate change and climate-related risks, along with the transition to a low carbon/carbon-neutral economy. Specific focus will be given to recent developments from the Bank of England (BoE) along with the pertinent tie through from the Australian Prudential Regulation Authority (APRA). 

The key take-away is that there exists a plethora of opportunities in the marketplace to stay ahead of the curve for businesses, industry and organisations alike. Where, LightPhi indicates the value they are proactively adding to stakeholders through; leveraging their global markets presence, subject matter expertise across industry and the practical measures at the disposal of C-Suites across the Australian landscape.

BoE Deep Dive

Financial resilience is of the utmost importance in the UK and it’s famed financial services sector. Through the pain points of the GFC to leading the uplift in global financial regulation. Today, there’s a different risk at play, and that is climate change. The BoE in December 2019 released its discussion paper; ‘The 2021 biennial exploratory scenario on the financial risks from climate change’, [1] addressing the importance of collaboration in the financial sector for building financial stability around climate-related risks.

Whilst the development of climate-related risks materialise over time, implementation approaches to measure such pertinent risks will ensure resilience when these risks eventuate. Consultation on the design is chiefly for feedback on feasibility and robustness, and so welcoming proposals from stakeholders including; firms, climate scientists, economists, and industry experts. The timeline before COVID-19 was 18 March 2020, with the framework published in the second half of 2020 and the view to publish findings in 2021.

Stress testing will be targeted toward the largest Banking and Insurers in the UK, as well as other participating firms. The focus areas of stress testing will be on the following; extended modelling horizon, broader participation of firms, multiple climate change scenarios, counterparty-level modelling expectations, and integrated climate and macrofinancial variables.

The BoE separates climate change risks into two main channels being Physical and Transitional risks, and their definitions are important to note. 

Physical risk borne out of the severity and frequency of climate phenomenon and weather-related events. These severely damage; infrastructure, disruption to businesses and supply chains, tourism, agricultural disasters, and more broadly lead to loss of life and migration. These pose risks to:

  • Asset values; 
  • Corporate profitability, and public finances;
  • Macroeconomic activity and lower productivity; and
  • Upswing in insurance premiums and costs of underwriting settlements.

Transition risk steams from the adjustment toward a low carbon/carbon neutral economy, which exacerbates structural change within an economy. Where the following issues arise from:

  • Fall in private wealth;
  • Market losses for investors.
  • Reassessment of asset values;
  • Declines in energy and fuels pricing; and
  • Systemic credit issues, increases in borrowers non-performing loans and these sitting on bank loan books.

APRA Deep Dive

APRA’s position on climate change along with international regulators is one which looks to encourage and implement frameworks which assess, manage and disclose the financial risks of entities pertaining to climate change.

This comes on the back of the prudential regulator’s 24 February 2020 letter to all APRA regulated entities, signalling the development and consultation of a Prudential Practice Guide (PPG) on climate change which will supplement the existing CPS 220 prudential requirements. Consultation is scheduled for mid-2020 with final guidance to be published at year’s end.

APRA along with the Reserve Bank of Australia (RBA) will undertake a climate change financial risk vulnerability assessment for Australian ADI’s. The assessment design will be completed in 2020, with execution in 2021, with the view to cascade this assessment into other industries. APRA’s SPG 530 will also be updated to reflect environmental, social and governance (ESG) considerations in the investment strategies of superannuation entity licensee’s. Consultation on changes to SPS 530 will also occur in mid-2020. [2]

The local response to climate-related risks in Australia has been encouraging, with APRA looking to ensure our financial system is sound and resilient when it comes to climate change and the risks it poses. The prudential regulator released an Information Paper on 20 March 2019, ‘Climate change: Awareness to action’, [3] Where reception has positive, welcoming and also demanding of the fact that Australia ensures its financial system is transparent in its financial disclosures, resilient in the face of climate-related risks, and the global transition toward a low carbon economy. [4] 

The prudential regulator’s climate change survey, included 38 of Australia’s largest financial services entities, including; banks, superannuation, holding $3tn in retirement savings, general Insurers, a $45bn sector, private health insurers, and life insurers. [5] Interestingly, when comparing and contrasting with the BoE’s BES 2021 discussion paper, APRA has classified climate-related risks into three risk categories:

Physical risk; looking at changing climate conditions and weather phenomenon.

Transition risk; encompassing policy changes, tech innovation and social adoption.

Liability risk; focusing on litigation and regulatory enforcements.  

Raising the risk awareness of climate change and the low carbon transition has been paramount for the prudential regulator. Interestingly, the survey indicated that out of the 38 entities surveyed across the five FS sectors; [3] 6% consider climate-related financial risk to be material, 80% are taking steps to improve their understanding of climate risks, under 50% are disclosing climate-related financial risks, and over 50% are undertaking quantitative financial analysis related to climate change. [3] The Information Paper indicated the following as the top six risks in their respective risk category: [4]

  1. Reputation, Regulatory, and Energy (Transition risks).
  2. Flood, Cyclone, and Bushfire (Physical risks).

Australia’s financial sector with the guidance of APRA will continue to take the initiative to raise awareness, develop products for the transferal of risk, and seize the opportunity to demonstrate leadership in relation to climate change. 

A World of Opportunity

In light of this, LightPhi firmly believes in the opportunities that exist in the marketplace and is actively partnering with business, industry and organisation in providing solutions around; financing energy efficient projects, renewable energy initiatives, carbon-neutral transport, green buildings and climate resilient infrastructure. 

LightPhi believes and actively seeks to add value to its clients, to capitalise on the opportunities to build stability and strength in the marketplace when it comes to climate change and the transition to a low carbon economy. LightPhi is proactively applying the following within its risk management practice for clients and stakeholders:

  • Stress testing; 
  • Scenario analysis;
  • Identification of data gaps;
  • Climate change modelling;
  • Climate risk considerations;
  • Policy documentation reviews;
  • Risk framework reviews and appetite setting; and
  • Practical implementation of climate-related risks and registers across services lines.

The time to capitalise on these opportunities is now and what better way than to partner with LightPhi and its Global Network of firms and affiliates across the globe.

Appendices

[1] https://www.bankofengland.co.uk/-/media/boe/files/paper/2019/the-2021-biennial-exploratory-scenario-on-the-financial-risks-from-climate-change.pdf?la=en&hash=73D06B913C73472D0DF21F18DB71C2F454148C80

[2] https://www.apra.gov.au/sites/default/files/2020-02/Understanding%20and%20managing%20the%20financial%20risks%20of%20climate%20change.pdf

[3] https://www.apra.gov.au/sites/default/files/climate_change_awareness_to_action_march_2019.pdf

[4] The Australian: “banks face climate stress tests as apra calls for improved internal systems”

[5] https://www.theaustralian.com.au/business/banks-first-in-line-for-apras-climate-stress-tests/news-story/c698283d8e00a315152403e62d77e49f

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