Climate Change Risk: APRA’s guidance for institutions

Recognising the threats that climate change brings, and the need for greater clarity around regulatory expectations, The Australian Prudential Regulation Authority (APRA) has released, for consultation, a draft prudential practice guide – Prudential Practice Guide CPG 229 Climate Change Financial Risks (CPG 229).

Importantly, CPG 229 does not impose any additional obligations on institutions in relation to climate risks. APRA has drafted the guide for the purpose of assisting APRA-regulated institutions to comply with the existing risk management and governance requirements in Prudential Standards CPS 220 Risk Management (CPS 220), SPS 220 Risk Management (SPS 220), CPS 510 Governance (CPS 510), SPS 510 Governance (SPS 510). It also provides suggestions that APRA considers are prudent practices in managing to climate change financial risks.

CPG 229’s governance, risk management, scenario analysis and reporting guidance reflects the widely accepted climate-risk disclosure framework developed by the Taskforce on Climate Financial Disclosures (TCFD ) for guiding institutions in the consideration and management of climate risk.

Whilst CPG 229 is only a guideline, APRA considers that prudent institutions should consider the opportunities and the financial risks of climate change in business and strategic decision-making. Institutions, particularly those in financial, banking and insurance should be looking at this in the context of international movement towards mandating climate risk disclosures and Australian legal expectations around how directors discharge their duties when it comes to climate change risks.

The international context

Around the world regulators and governments are taking strong action to address the growing threats of climate change including setting emissions targets and making climate risk disclosures mandatory for some entities. The TCFD disclosure framework has gained global recognition and support as the foundational framework for climate risk reporting with many jurisdictions moving to make TCFD-aligned disclosures mandatory. Amongst Australia’s trading partners taking such action are the United Kingdom, New Zealand and Hong Kong.

The New Zealand government is working towards making climate-related disclosures mandatory through introducing an amendment to the Financial Markets Conduct Act 2013 to Parliament. If approved, from 2022 FMC-reporting institutions will need to start making climate-related disclosures.

The UK Treasury has published a strategy towards mandatory climate-related disclosures which will also be aligned to the TCFD recommendations for disclosures (A Roadmap towards mandatory climate related disclosures. November 2020). This proposal for mandatory disclosures quickly follows the expectation set out by the UK in 2019 in the Government’s Green Finance Strategy for listed issuers and large asset owners to make voluntary disclosures. A cross UK Government and regulator Taskforce (the UK Taskforce) determined that the urgency of the climate threat means that a voluntary approach may be insufficient.

Hong Kong’s Green and Sustainable Finance Cross-Agency Steering Group (Steering Group) has developed a Strategic Plan setting out 6 key focus areas for strengthening Hong Kong’s financial system to support a more sustainable future. Among other things, the plan includes making TCFD- aligned climate-related disclosures mandatory across relevant sectors no later than 2025.

The Australian legal context

Australian barristers Noel Hutley SC and Sebastian Hartford Davis have recently written a second supplementary memorandum of opinion to their original 2016 legal opinion on climate change and directors’ duties. They conclude that, whereas in 2016 their opinion was based around what directors could and should be doing, in 2019 they observed an exponentially rising risk of liability for directors and now, with the growing regulatory, investor and community pressure, they found the focus was on how directors are discharging their duty.

Hutley and Hartford Davis are of the opinion that, it is no longer safe to assume that directors adequately discharge their duties simply by considering and disclosing climate-related trends and risks. In relevant sectors, directors of listed companies must also take reasonable steps to see that positive action is being taken to identify and manage risks, to design and implement strategies, to select and use appropriate standards, to make accurate assessments and disclosures, and to deliver on their company’s public commitments and targets.

They also found a risk that if companies and directors make inaccurate climate-related statements and disclosures, including flawed climate scenario analysis and making “net zero” commitments that are misleading or made without a reasonable basis, they will breach a number of Acts including the Corporations Act 2001, ASIC Act 2001 and Australian Consumer Law. To avoid falling foul of these laws, a company and its directors, must have a genuine intention, on reasonable grounds, to follow through with reasonable strategic efforts and commitment of to fulfil the intent implied by announced targets.

What is the purpose of CPG 229?

CP229 was drafted to assist APRA-regulated institutions to develop processes to:

1. Understand the risks and opportunities of climate change and the transition to a low carbon economy;
2. Ensure investment, lending and underwriting decisions are well-informed; and
3. Implement proportionate governance, risk management, scenario analysis and disclosure practices in line with the TCFD recommendations.

APRA acknowledges that while climate risks can be managed within broader risk management frameworks, because the financial risks associated with climate change can differ from other financial risks a different management strategy may need to be developed to deal with climate risks.

The particularities of climate risks and risk management can include:

1. The uncertainty of future events, systemic, globally disperse and long-term nature of climate risks make the identification and quantification of risks and understanding the potential impacts on the business difficult.
2. Changes which may be irreversible and difficult to mitigate.
3. The uncertainty of future events making it necessary to monitor the risks through regularly upgraded qualitative and quantitative metrics.
4. The use of scenario analysis to inform the understanding of potential long term risks and opportunities. The unprecedented nature of climate change, means that historical data and backward-looking risk assessment methods are unlikely to adequately anticipate future impacts and as new data is collected, future impacts are revised.
5. The importance of reporting relevant information to the board and senior management to enable fully informed decision-making and response strategies, and where needed, in making external disclosures of material risks.

What should APRA- regulated institutions be doing to meet CPG 229 recommendations for best practice?

GOVERNANCE

With board oversight, climate change risks should have sufficient standing in the institution and an institution-wide consistent strategic response.

There is a strong emphasis on the Board’s ultimate responsibility and the importance of the directors seeking to understand and regularly assess the financial risks arising from climate change that affect the institution now and in the future. The Board will need to be able to provide evidence that it has appropriate oversight of material risks.

This means having appropriate board training, regular reporting as risks, metrics and data evolve, ensuring processes for monitoring the exercise of climate change risk management functions delegated to senior managers.

CLIMATE CHANGE RISK MANAGEMENT

APRA-regulated institutions are guided to take a strategic and risk-based approach to managing climate change risk and there is an emphasis on the need for the Board to understand the interaction between climate risks and their business activities, and the compounding effect climate risks may have on an institution’s other risks.

Although the precise form and extent to which climate risks will materialise cannot be predicted, financial risks certainly will materialise as a result of climate change. The magnitude of the financial impacts of these risks can be managed and mitigated, and opportunities from the transition to a low-carbon economy taken, through understanding the potential risks.

Polices & Procedures

Include steps for considering and management of climate risks in written policies and procedures developed under the institution’s normal risk management framework.

Risk Identification

APRA notes that it is prudent to seek to understand climate risks and how they may affect the business model, including being able to identify material climate risks and assess the potential impact on the institution.

It is recommended institutions conduct scenario analyses, with both a short- and long-term time horizon and record how you determined the materiality of climate risk within each of the risk categories identified in CPS 220 and SPS 220.

An Internal Capital Adequacy Assessment Process (ICAAP) is considered to be an appropriate framework to consider and record the material impact on capital adequacy of climate risks for those institutions required to complete an ICAAP. An institution that is not required to complete an ICAAP may also benefit from adopting a similarly formal approach to recording material exposures and how the assessment of those exposures is considered.

Risk Monitoring

APRA noted that the better practice in monitoring climate risks is to include both a qualitative and quantitative approach using metrics that are appropriate to the institution’s circumstances to gain understanding of the potential current and future impacts of climate risks on its customers, counterparties, and institutions to which the institution has an exposure.

Regularly update climate risk data and metrics. Consider triggers to initiate a review of strategy or engagement with customers and counterparties. Monitor the impacts that climate risks may have on outsourcing arrangements, service providers, supply chains and business continuity planning.

Risk Management

Where climate risks are identified as material to the include them in risk mitigation and exposure plans. Regularly review and assess the effectiveness of those plans.

APRA expects institutions to work with customers, counterparties and organisations that face higher climate risks, to help improve the risk profile of those institutions. If the risks cannot be removed they should look at other ways to mitigate any third party risks imposed on the APRA -regulated institution.

Consider financial assistance to the stakeholder and if risks remain, limiting exposure to the entity or sector or discontinuing the relationship.

Climate Change Risk Reporting

The Board and senior management need relevant, up to date information to make informed decisions. The extent and frequency of reporting will depend on nature and magnitude of risk exposure.

Develop and implement procedures to routinely provide relevant information on material climate risk exposures, including monitoring and mitigation actions to the Board and senior management.

SCENARIO ANALYSIS

Institutions should use scenario analysis and stress testing capabilities to inform their risk identification in both the short and long term. They can either develop expertise in-house or use third party services. APRA recognises that this is a developing and complex area.

For an APRA-regulated institution required to complete an ICAAP, APRA considers a narrative-driven process to be a useful approach to considering climate risk scenario analysis and stress testing to assess potential risk exposures and available capital resources.

Maintain appropriate documentation of the process and results of climate risk scenario analysis and stress testing. Report material risks to the Board and senior management. Use the outcomes of the scenario analysis of stress testing to inform business planning and strategy development.

CLIMATE CHANGE DISCLOSURE

The demand for reliable and timely climate risk disclosure will increase over time, and for institutions with international activities there is a need to be prepared to comply with mandatory climate risk disclosures in other jurisdictions.

The TCFD framework is becoming the standard format for disclosure of climate change risks for consistency in Australia and other jurisdictions.

Next steps

What actions should the Board or Senior Officer Outside Australia (for a local Branch) be taking?

1. Include climate risk on the agenda at the Board and sub-committee levels including appropriate training for Board members;
2. Set clear roles and responsibilities for senior management in the management of climate risks, and hold them accountable for fulfilling these responsibilities;
3. Regularly re-assess the short and long term climate change risks and ensure these are considered in approving the institution’s strategies and business plans; and
4. Ensure that the institution’s risk appetite framework incorporates the risk exposure limits and thresholds for the financial risks that the institution is willing to bear from climate change, particularly in respect to climate risks considered to be material.

What actions should Senior Management be taking?

1. Assess and manage climate risk exposures using and adapting the existing risk management framework, including developing and implementing appropriate policies;
2. Review the effectiveness of the framework, policies, tools and metrics on a regular basis and revise as needed;
3. Make timely recommendations to the Board on the institutional objectives, plans, strategic options and policies as they relate to climate risks that are assessed to be material, including development and use of relevant tools, models and metrics to monitor exposures to climate risks; and
4. Ensure adequate resources, skills and expertise are allocated to the management of climate risks, including through training, development of senior staff and use of qualified advisers.

In developing the above strategies to satisfy CPG 229, the Board and Senior Management need to be able to demonstrate that they had reasonable grounds for making future representations, including of climate risk and mitigation effects, in setting emissions reduction targets and making net zero claims.

To avoid the risk of litigation for misrepresentation, directors and senior management should:

1. Integrate decarbonisation targets into the institution’s operational strategy, rather than relying on outside contingencies and the supply chain decarbonising their operations.
2. Record the drivers and assumptions that underpin the decarbonisation strategy, paying particular attention to reliance on carbon offset schemes.
3. Test the assumptions and document the decision-making process.
4. Detail which type of emissions are included in carbon reductions commitments and zero emissions claims.
5. Promptly disclose information that makes reaching the claimed target unfulfilled or untenable.

How we can help you on your climate change journey

We are here to help in a number of ways as your organisation starts, or continues, its climate change risk journey. This can include:

• Climate-risk awareness and TCFD compliance training.
• Facilitating workshops and financial climate change impact assessments to identify and understand the threats that climate change pose to your organisation.
• Perform scenario analyses of the threats identified looking at different possible scenarios over the short, medium and long term over a particular asset, activity or area.
• Provide a roadmap to enhance the organisation’s climate change risk management strategy.
• Conduct reviews to ensure regulatory disclosures are robust and relevant.

How far do you want to go to minimise the impact of climate change on your business? Be more resilient and contact us to discuss your needs.