In response to appeals from the wider industry to have improved clarity on the regulatory expectations for managing the financial risks of climate change, APRA has released a draft prudential practice guide (CPG 229) for banks, insurers and super funds.
This guide explores examples of sound practice in areas including governance, risk management, scenario analysis and disclosure but does not act to enforce new commitments. Instead, flexibility in adopting a risk management approach remains with the board of directors and senior management.
The risks of climate change
The implications of climate change extend into the financial sector and are inherently different to other financial risks due to its long-term horizon and practically irreversible nature (within one’s lifetime). As a result, they are difficult to alleviate and are pivotal for companies to consider in their decision-making. These climate risks can be broadly categorised into 3 groups:
- Physical risks: climate change is forecast to lead to changes in the frequency, severity, and geospatial location of natural perils resulting in higher volatility and quantum of property damage and reduced asset values.
- Transition risks: in response to climate changes, there may be government policy change, social adaptation, market changes and advancements in technology to manage these risks. These may impact the profitability and investment decisions of organisations.
- Liability risks: in response to the impacts of climate change, there may be legal pursuits of directors and board members if impacts of climate change are not adequately addressed or considered in the operation of the business.
Despite the difficult-to-navigate complications that come with climate change, there are also many opportunities as companies adapt, with every institution responding differently depending on their business strategy, size, and customer base.
This article summarises the key sections of the practice guide below.
Governance – the roles of the board and senior management
The CPG229 guide states that the role of the board includes:
- Ensuring there is an awareness and opportunity to discuss climate change issues at the Board and sub-committee levels;
- Setting roles and accountabilities for senior management; and
- Setting long-term and short-term strategy and risk appetite with considerations of these climate risks;
The roles of senior management are more operational and involve the implementation of the risk management framework for climate-related risks, including:
- Utilising an institution’s risk management framework to assess and manage climate risk exposures on an ongoing basis;
- Reviewing the risk management framework periodically to assess its effectiveness;
- Making recommendations to the board on strategic objectives and metrics to monitor weather-related exposures; and
- Ensuring that there are sufficient and adequate resources in the business allocated to manage and address climate risks.
Risk management – What does sound practice look like?
Given the importance of a company understanding the interaction between climate change and their own business model, APRA has advised that a prudent institution should identify climate-related risks to the business by developing a risk criterion. Factors that constitute this criterion may include vulnerability to extreme weather events, levels of greenhouse emissions, potential exposure to changes in climate related policy or technology and/or any linkages to unsustainable practices.
APRA recommends that these risks are monitored through qualitative and quantitative metrics. This could be performed on a geospatial or economic sector level and some examples of metrics include indirect emissions and loss of investment returns. This monitoring process would assist APRA in understanding the impact of climate change across various institutions and industries.
These recommendations would inform the board in designing a mitigation plan and assist with ease of reporting on a regular basis.
The development of stress and scenario testing would assist with the identification of risks and inform a further understanding of the underlying exposures of an institution to certain elements of climate risk. The implications of this would impact the solvency and capital held by the business to meet obligations. The Internal Capital Adequacy Assessment Process (ICAAP) framework may be a useful framework to use as a measure of capital sufficiency for the climate risks relevant to the institution.
Qualitative and quantitative analysis can be undertaken, with examples of key considerations for developing scenarios including future temperature rise, economic/technological shifts, time horizons, geography and the potential for compounding natural perils.
Prudence can be demonstrated through documentation of the analysis and communication of results to the board if results are material. This would raise awareness amongst senior management and the board to re-asses business strategy and capital or liquidity maintained by the institution.
Disclosure – Being perceived by the public
With increased scrutinization on the climate risk management of companies, a disclosure of relevant climate information can inform stakeholders and investors on key decisions. As demand for climate disclosures continues to grow, companies can enhance transparency and reaffirm market confidence in their climate risk management framework.
What does this mean for actuaries?
The modelling rigor, financial expertise, and experience with long time horizons and uncertain outcomes that actuaries have built a reputation for can be leveraged to proactively manage climate risks. This guidance provides clarity on what is expected in terms of qualitative and quantitative management of these risks. As this becomes an increasingly crucial consideration across all of society, the skills and expertise of actuaries will be crucial to a diverse range of industries/sectors.
The released version of the CPG229 guidance is currently a draft, and APRA has invited institutions and individuals to provide feedback to the guidance by 31 July 2021 with an aim to finalise at the end of 2021.
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