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Climate Risk: Get Ready For Green Swan Events

January 2020 saw the Bank of International Settlements (BIS) introduce a new risk into the lexicon when they used the term “Green Swan” to describe climate change risks that are potentially extremely financially disruptive events that could be behind the next systemic financial crisis.

“Green swans or ‘climate black swans’ present many features of typical black swans,” said the authors, who include BIS Deputy General Manager Luiz Pereira da Silva. “Traditional approaches to risk management consisting in extrapolating historical data and on assumptions of normal distributions are largely irrelevant to assess future climate-related risks.”

In Australia, many businesses have experienced their own Green Swan events during the 2019/2020 bushfires over summer. The obvious ones are tourism businesses in bushfire ravaged holiday locations and local businesses in fire and drought stricken country. Further afield, businesses that use road or rail to transport their goods or source product have experienced difficulties with road and rail closures due to bushfires.

A recent survey of global business leaders (The Fourth Industrial Revolution: At the intersection of readiness and responsibility) found that 81% of Australian executives believe climate change will harm their company.

The views of Australian executives align with The World Economic Forum’s 2020 Global Risk Report which said that “Climate-related issues dominated all of the top-five long-term risks in terms of likelihood”. Climate risks have bumped “Technological risk” (eg cyberattacks, data fraud) from two of the top- five places. The report also shows that climate-related risk tops three of the top-five risks in terms of impact.  Whatsmore, severe weather events or climate change risks have featured heavily in many lists of the top 10 risks by many researchers in recent years.

It’s time to take action.  Its time to put in place measures to prevent, prepare and respond to the climate change impacts.

What financial risks are associated with climate change?

Climate change risks have generally been classified into Physical Risks and Transition Risks.

Physical Risks

Physical risks are the risks that result directly from impacts of climate change on our environment such as rising global temperatures, extreme heat or cold, heatwaves, floods, droughts, extreme storms, catastrophic fires, rising sea level and disease.  These risks can be further categorised as:

  1. Acute, which are event driven, for example severe storms and floods; and
  2. Chronic, which refer to longer term shifts in climate patterns, for example changed rainfall patterns, chronic heatwaves and droughts and rising sea levels.

The consequences of physical risks can include limited or restricted resource availability, supply chain disruptions and damage to assets.

Transition Risks

For a number of years, Australian and international regulators, including the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC), as well as central banks, including the Reserve Bank of Australia (RBA), have become increasingly concerned and vocal about the financial impacts that climate change has on domestic and international economies. The International Monetary Fund (IMF) has warned that the world economy is increasingly vulnerable to the impact of climate change and as a result has downgraded its economic forecasts for 2020 and 2021. It is urging governments to do more to reduce carbon emissions.

Transition risks are risks that arise from the world’s transition to a low carbon economy. These risks can be broken down to four areas:

  1. Policy and legal
    • Government emissions reduction commitments
    • Policy for alignment with the Paris goals
    • Internal and international carbon pricing pressures (including the EU’s indication that it will impose border carbon adjustments for goods from countries that do not have as stringent carbon targets)
    • Compliance
    • Litigation
  2. Technology
  3. Market drivers
    • Competitors
  4. Reputation
    •  Employee expectations
    • Investor expectations and demands
    • Activism

The consequences may include increasing costs of fuel and energy, carbon pricing, stranded assets, the cost of new technologies and resources, market movements and changing customer and investor preferences and sentiment. These can result in corporate asset devaluation and lower corporate profitability.

The benefits from understanding and responding to climate change risks

All organisations will benefit from identifying the climate change risks and potential their impacts on their businesses, currently and in the future under different scenarios. Some companies are legally required to act on climate change risk.

Understanding the risks and opportunities of climate change enables organisations to develop mitigation, adaptation and resilience strategies for sustainable economic growth and ensuring compliance with reporting requirements as required.

Compliance Requirements in Australia

Australian corporations are governed by laws and regulations requiring disclosure of information relevant to operations, financial positions, business strategies and any matter considered to be material to the value of an entity’s securities. Regulators have been expressly including climate change risk amongst the risks that must be considered and should be disclosed. For example:

  • The Corporations Act requires corporations to disclosure reasonably foreseeable material risks. Recent legal opinions (from Noel Hutley SC and Sebastian Hartford-Davis) as well as the financial services royal commissioner, Kenneth Hayne’s remarks to the Centre for Policy Development’s Business Roundtable on Climate and Sustainability, make it clear that a director must take account of climate related risks and issues that are relevant to the company and the board must publicly report on these. Specifically, company’s directors:

i) must determine if climate change poses foreseeable, material risks to the company’s business and disclose the information required by shareholders to make an informed assessment of the business’s strategies and prospects for future financial years, and

ii) have a duty of due care and diligence under the Corporations Act. A lack of directors’ knowledge of the real risks and opportunities of climate change is a major governance failure and directors failing to adequately consider the impacts of climate change risk for their business may breach these duties.

  • The Australian Securities Exchange (ASX) recommends (Corporate Governance Principles and Recommendations – Recommendation 7.4) that listed entities disclose material exposure to economic, environmental and social sustainability risks and their management strategies for dealing with these risks. If they choose not to make such disclosures, they must disclose the reason for failing to follow the recommendation.
  • The Australian Securities and Investments Commission’s (ASIC) Regulatory Guide 247 expresses the requirement that an Operating and Financial Review for a listed entity should include a discussion of environmental and other sustainability risks including climate risk where those risks could affect the entity’s achievement of its financial performance or outcomes disclosed.  Regulatory Guide 228 sets out further detail and explicitly addresses the disclosure of environmental and regulatory risks in a prospectus where climate change risk and opportunity will be material to a company’s prospects.
  • The Australian Accounting Standards Board (AASB) and Auditing and Assurance Standards Board (AUSB) have issued a joint bulletin on climate risk assumptions and disclosure requirements in accounting estimates and financial statements. Making false representations and non-disclosure in annual reports can result in prosecution for misleading or deceptive conduct.
  • The Australian Prudential Regulation Authority (APRA) considers that climate risks can be financial in nature, foreseeable, material and actionable now. APRA has revealed that it will be developing climate change stress tests for banks, superannuation funds and insurers within its supervisory priorities for 2020 and more closely assessing institutions’ capability to deal with emerging and accelerating climate change risks.

How can companies and their directors comply with these obligations?

Several frameworks have been established around the world for reporting on climate risks.

The one that has received the most common support and is supported by both ASIC and APRA is the framework developed by The Financial Stability Board-Taskforce on Climate-related Financial Disclosures (TCFD). The TCFD recommends a framework for making climate risk disclosures around Governance, Strategy, Risk Management and Metrics and Targets.

The TCFD reporting framework is aligned with the reporting requirements of the SASB sustainability
accounting standards (the SASB standards and the Climate Disclosure Standards Board (CDSB) Framework for Reporting Environmental Information and Natural Capital (the CDSB Framework).

Where do you start down the TCFD pathway?

The TCFD has identified that companies are having difficulty implementing the recommendations and making comprehensive disclosures in their financial reports.

Before an organisation can make its disclosures, it must have integrated climate risk assessment, monitoring and management into its financial and strategic decision- making, governance, risk management and operations.

Steps to take to prepare for reporting and set out on a resilient sustainable course are:

  • Ensure the board of directors and executive leadership is committed.
  • Establish a Committee to oversee the climate-risk process working with the organisation’s risk and audit committees.
  • Assess the financial impacts of climate events on your business including critical third parties.
  • Perform scenario analyses (this can be on the entire business or particular areas at higher risk).
  • Adapt the organisation’s enterprise risk management.
  • Obtain investor and stakeholder feedback on the information that they want to know about the company’s climate related risks and opportunities and what it is doing to address these.
  • Use or adapt existing tools to collect and report on climate-related financial information wherever possible.
  • Implement internal review, monitoring and control to ensure disclosures are robust, accurate and relevant. Consider the benefits of external assurance.
  • Use the same level of quality assurance and compliance for climate-related financial information as used for other disclosures.
  • Integrate climate-related financial information into the existing annual reports, tying in to the TCFD recommendation’s around governance, strategy, risk management, target-setting and performance.

How we can help

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.