One of Australia’s top financial regulators delivered a speech entirely about climate change on Friday.
Specifically, it was about the risks of climate change for financial institutions.
Geoff Summerhayes is one of the three “members” of APRA, along with chair Wayne Byres and Deputy chair Helen Rowell. As with any prepared comments from a supervisor, his speech to the Insurance Council of Australia’s conference would have been approved by the senior executive.
But why is a prudential supervisor talking about something normally tagged “Environment”? Isn’t it just another unpriced externality which we can assume is either priced in, or can be safely ignored?
Put simply, climate change is already creating winners and losers in many markets. And it’s not going to go away anytime soon. Mark Carney’s speech in September 2015 outlined why markets are struggling to accurately price in climate risk, and why that is a problem for central banks and other financial supervisors.
Look at thermal coal consumption, which has passed its peak now, years earlier than anyone expected. Look at renewables, which have fallen in price faster than virtually any mainstream forecaster anticipated.
In Australia, many of us are still under the impression that climate change is a “political” matter. But investors have long known that’s not the case. For all the noise over lumps of coal in parliament, no-one is going to finance a coal-fired power plant in this country without a solid gold government guarantee.
This is the first time APRA has clearly addressed the topic of climate risk
Importantly, Summerhayes addressed all key types of climate risk as identified by the Bank of England’s Prudential Regulatory Authority in 2015.
- Physical risk: arising from the effects of climate change;
- Transition risk: around the risks associated with shifting towards a zero net emissions economy
- Liability risk: which can arise from either of the above risks and has particular importance to company directors, trustees, and insurers (but also can affect others).
APRA is not just thinking about natural catastrophe risk to insurers
Summerhayes pointed out that financial risks from climate change used to be thought of as something that’s only a worry for insurers who are exposed to natural catastrophe losses. But as laid out in the three categories above – physical, transition, and liability – climate-related losses (and even gains) can arise in other ways.
In fact, Summerhayes made clear that he thinks transition risk may be a bigger concern right now than risks arising from climate change effects. For example, he said:
There are a variety of other potential issues. These include the potential exposure of bank’s and insurers’ balance sheets to real estate impacted by climate change and to re-pricing (or even ‘stranding’) of carbon-intensive assets in other parts of their loan books. They also include exposure of asset owners and managers – an important consideration given the size of Australia’s superannuation sector and its heavy weighting towards carbon-intensive equities and a relatively resource-intensive domestic economy.
However, Geoff Summerhayes’ speech goes further – for the simple reason that is more recent. He noted that the three recent developments that have made climate a far more proximate concern for APRA.
- One is the 2015 Paris Agreement – which passed into force last year and commits the world to limit warming to well below 2C. This won’t be a small effort — net emissions will have to get to zero by about 2050 to have a decent chance.
- Another is the FSB Task force on Climate-related Financial Disclosures, which released its draft recommendations in December. That includes elements such as: companies should undertake scenario analysis to test how they may perform in a <2C world. Although the task force’s disclosure framework is voluntary, it comes under the auspices of the FSB, and investors are already showing a strong interest in using it to extract better disclosure of climate risks from companies.
- Lastly, the fears of liability risk for companies directors and others who failed to take reasonable efforts to understand and manage climate risks and opportunities.
Climate change risks are evolving quickly, and merely measuring your carbon emissions will probably not be adequate. Looking ahead to understand foreseeable risks and opportunities will be key. Expect to hear much more about scenarios.
Or, as Summerhayes describes it:
Practice and expectations are moving beyond mere documentation of static metrics. Robust, scenario-based thinking about risks should be the new standard for risk management. Markets and investors expect to see evidence of more sophisticated analysis to identify risks and strategy for managing them. The questions investors (and regulators) will want answered are not just about “what” but “how”. How do you model and identify relevant trends, opportunities and risks? How robust are your strategies given different scenarios and contingencies?
Here’s some recommended further reading on how to get up to speed on financial climate risk:
- The memorandum of opinion by Noel Hutley SC on director liability, published in October 2016, received a lot of attention in the Australian business world. In his speech, APRA’s Summerhayes referenced this document, and the Centre for Policy Development’s roundtable with Dr Paul Fisher from the Bank of England on launching the Hutley opinion.
- Sarah Barker from Minter Ellison in Melbourne has been a driving force – in fact, is arguably a world leader – in analysing and communicating this emerging director liability risk relating to climate change. Keep an eye out for her – if you see her speak you’ll never think about climate change the same way.
- The Actuaries Institute and Sharanjit Paddam in particular, who chairs the institute’s climate working group & is an actuarial principal at Deloitte. The Actuaries’ Institute published a paper late last year on managing climate risk in the financial sector.
- The Climate Institute’s paper on systemic financial risks to Australia also published around the same time & (this preceded the Bank of England’s official pronouncements on the topic).
- Summerhayes’ speech also references climate impact risk to Australian housing, which we also explored in a 2016 paper.
- Summerhayes also cited a package of December publications from the Governance Leadership Centre at the Australian Institute of Company Directors. The main report of this I co-authored with Dr Nick Wood of Climate Policy Research Ptd Ltd. It includes some useful information about developments in physical climate modelling. Many of Australia’s big super funds and asset managers are active in the Investor Group on Climate Change, whose members totals about $1tn AUM. IGCC makes many documents available to the public, including sector-specific “expectations” for companies (oil and gas, automotive).
Remember: with risks come opportunities. This is an area worth being on top of early; it will only continue to grow in importance.
Kate Mackenzie is the Head of finance and Investment at The Climate Institute.