Australia welcomes further guidance on improving climate-related financial risk management by banks and supervisors

Scenario analysis and stress testing on climate-related financial risks for financial institutions has become an increasing focus for regulatory bodies both in Australia and overseas. Calls for more robust practices in this area were first given global prominence in 2017 following the publication the recommendations of the Taskforce for Climate Related Financial Disclosures (TCFD). The TCFD recommendations, amongst other matters, encourage companies to undergo scenario analysis and stress testing in order to assess the materiality of climate-related risks.

This article charts the recent developments in this area including the Basel Committee on Banking Supervision’s (Basel Committee) draft principles on the effective management and supervision of climate-related financial risks (the Draft Principles) and the Australian Prudential Regulation Authority’s (APRA) Prudential Practice Guide CPG 229 Climate Change Financial Risks (CPG 229).

The Basel Committee’s draft principles on the effective management and supervision of climate-related financial risks

In November 2021, the Basel Committee released for consultation its Draft Principles on the effective management and supervision of climate-related financial risks.

The Draft Principles propose 18 principles to improve climate-related financial risk management by banks and supervisors covering corporate governance, internal controls, risk management, monitoring and reporting, and scenario analysis.

The Basel Committee intends to monitor implementation across member jurisdictions, including Australia, to promote a common understanding of expectations, support the development of harmonised practices and facilitate implementation of the principles as soon as possible.

What has been the response to the Draft Principles?

The consultation period for the Draft Principles closed on 16 February 2022. Although industry feedback has been broadly supportive of the recommendations, more clarity has been sought in relation to the implementation of the scenario analysis requirements set out in Principle 12, including calls for the final guidance to clarify how stress testing and internal capital and liquidity adequacy assessments under Principle 12 are expected to differ from traditional supervisory stress testing. There are concerns that traditional stress testing is inappropriate for assessing climate-related risk given the uncertainties around when these risks will materialise.

Developments for APRA-regulated entities in managing climate-related financial risk

The Climate Vulnerability Assessment

In parallel to the above developments, in September 2021 APRA launched a Climate Vulnerability Assessment (CVA) of Australia’s five largest banks.

The CVA is designed to assess the nature and possible impact of climate-related financial risks on banks' lending exposure under two different scenarios:

  • delayed transition scenario: this assumes that current climate policies stay the same until 2030, with a rapid reduction in greenhouse gas (GHG) emissions after 2030; and
  • current policies scenario: this assumes that only existing policies preserved and that GHG emissions continue to rise beyond 2050, peaking in 2080.

The CVA is not a traditional capital stress test since it 'does not include capital adequacy components and its results do not lead to direct prudential requirements'. Rather, the CVA focuses on transition and physical climate risks arising in Australia which could directly impact Australian lending. The participating banks have been required to assess residential mortgages, corporate and business lending exposures with credit risk being selected as the primary lens to assess climate-related risk.

APRA intends to publish the aggregated results from the CVA in 2022 and will consider extending the CVA to include the insurance and superannuation sectors in the future.

Prudential Practice Guide CPG 229 Climate Change Financial Risks

In November 2021, APRA released the final version of CPG 229 after a consultation period ending in April 2021. CPG 229 is designed to assist APRA-regulated institutions with managing climate-related risks and opportunities within their existing risk management and governance practices and is a direct response to industry requests for greater clarity of regulatory expectations in these areas.

While CPG 229 does not create any new regulatory requirements or obligations, it supports compliance with APRA’s existing risk management, governance requirements and reporting standards. This includes Prudential Standards CPS 220 Risk Management (CPS 220), SPS 220 Risk Management (SPS 220), CPS 510 Governance (CPS 510) and SPS 510 Governance (SPS 510). CPG 228 is comprised of four key sections: scenario analysis, disclosure, governance and risk management. The table at the end of this article highlights some of APRA's observations and suggestions across these key sections.

Comparison of the Basel Committee’s Draft Principles, APRA’s CPG 229 and the TCFD Recommendations

There is broad overlap between the Draft Principles, CPG 229 and the TCFD recommendations

For example, banks seeking to align with the guidance on climate-related governance and internal controls in principles 1-3 of the Draft Principles are also likely to align with the equivalent guidance in CPG 229. The table at the end of this article highlights the overlapping content in each of these publications.

What do these developments mean for Australian banks?

APRA supervised banks should consider the guidance set out in CPG 229 and commence aligning their existing governance, risk management and disclosure procedures with this guidance, if they have not already done so. Banks should also anticipate further changes to APRA’s prudential standards and/or related guidance should APRA determine this is necessary to implement the Draft Principles in Australia.

Given the broad alignment between the Draft Principles, CPG 229 and the TCFD recommendations, Australian banks who are already reporting in line with the TCFD recommendations and implementing the broader risk management and governance practices set out in CPG 229 will be well positioned to satisfy the requirements of the Draft Principles to the extent these are implemented in Australia.

The Draft Principles

CPG 229 / CPS 220 / SPS 220 / CPS 510 / SPS 510

TCFD Recommendations

Governance and internal controls

Principle 1: Banks should develop a process for understanding and assessing the potential impact of climate-related risk drivers on their businesses and operations. This should include consideration of both physical and transition risks that could materialise over different time horizons.

Principle 2: Banks should clearly delegate climate-related responsibilities to members and committees and exercise effective oversight of climate-related financial risks throughout the bank’s organisational structure.

Principle 3: Banks should adopt policies, procedures and controls to be implemented across the entire organisation to ensure effective management of climate-related financial risks.

Principle 7: Banks should ensure their internal reporting systems are capable of monitoring material climate-related financial risks and producing timely information to ensure effective board and senior management decision-making.

In providing guidance on compliance with CPS 510 and SPS 510, CPG 229 states that APRA considers it prudent practice for the board to seek to understand and regularly assess the financial risks arising from climate change. This includes board-level engagement, board training and setting clear roles and responsibilities of senior management in the management of climate-related risks. Banks should be taking both a short-term and a long-term view.

 

Entities should disclose their approach to governance of climate-related risk and opportunities by describing:

  • the processes and frequency by which the board and/or board committees are informed about climate-related issues;
  • whether the board and/or board committees consider climate-related issues when reviewing and guiding business activities including major capital expenditure, annual budgets, acquisitions and divestitures;
  • how the board monitors and oversees progress against goals and targets for addressing climate-related issues;
  • whether the organisation has assigned climate-related responsibilities to management-level positions and, if so, whether such management positions report to the board or a committee of the board and whether those responsibilities include assessing and/or managing climate-related issues; and
  • how management monitors climate-related issues.

Risk management

Principle 4: Banks should incorporate climate-related financial risks into their internal control frameworks across the three lines of defence to ensure sound, comprehensive and effective identification, measurement and mitigation of material climate-related financial risks.  The three lines of defence are:

  1. undertake climate-related risk assessments during the client onboarding, credit application, and credit review processes;
  2. undertake independent climate-related risk assessment and monitoring, including challenging the initial assessment conducted by the first line; and
  3. carry out regular reviews of the overall internal control framework and systems in the light of changes in methodology, business and risk profile, as well as in the quality of underlying data.

Principle 6: Banks should ensure that their risk appetite and risk management frameworks consider all material climate-related financial and establish a reliable approach to identifying, measuring, monitoring and managing those risks.

Principle 8: Banks should understand the impact of climate-related risk drivers on their market risk management positions and ensure that market risk management systems and processes consider material climate-related financial risks.

Principle 9: Banks should understand the impact of climate-related risk drivers on their market risk positions and ensure that market risk management systems and processes consider material climate-related financial risks.

Principle 10: Banks should understand the impact of climate-related risk drivers on their liquidity risk profiles and ensure that liquidity risk management systems and processes consider material climate-related financial risks.

Principle 11: Banks should understand the impact of climate-related risk drivers on operational risk and ensure that risk management systems and processes consider material climate-related risks. Banks should also understand the impact of climate-related risk drivers on other risks and put in place adequate measures to account for these risks where material. 

Under CPS 220 and SPS 220, APRA considers it prudent for climate risks to be considered within a bank’s existing framework, including the board approved risk appetite statement, risk management strategy and business plan. A bank should identify, measure, monitor, manage and report on its exposure to climate-related risks. This can include developing both qualitative and quantitative metrics, setting climate-related targets, developing plans to mitigate and manage material risks and routinely reporting on material exposures to the board of directors.

 

Entities should disclose their risk management process for identifying and assessing and managing climate-related risks by outlining:

  • whether they consider existing and emerging regulatory requirements specific to climate change;
  • their processes for mitigating climate-related risks;
  • their processes for prioritising climate-related risks and how materiality determinations are made; and
  • how their processes for identifying, assessing, and managing climate-related risks are integrated into their overall risk management framework.

Scenario analysis and stress testing

Principle 12: Banks should utilise scenario analysis, including stress testing, to assess the resilience of their business models and strategies to a range of climate-related pathways and determine the impact of climate-related risk drivers on overall risk profile. These analyses should consider physical and transition risks as drivers of credit, market, operational and liquidity risks over a range of time horizons.

APRA notes that best practice for scenario analysis and stress testing involves:

  • a shorter-term assessment of the bank’s current exposures to climate-related financial risks;
  • a longer-term assessment of the bank’s future exposures to different climate-related scenarios extending to 2050 and considering the rise of future temperatures or economic transition pathways;
  • incorporating both quantitative and qualitative factors into scenarios used to project future financial conditions;
  • assessing both physical and transition risks within each scenario;
  • consulting with external experts while maintaining appropriate internal knowledge and oversight to ensure the results of any outsourced analysis are credible;
  • measuring the impact of climate-related risks on capital adequacy, liquidity, and the ability to meet obligations to depositors, policyholders and superannuation fund members; and
  • consider future trends in catastrophe modelling, technology innovation or policy development (CPG 229, paragraphs 36-44.).

In undergoing scenario analysis, the TCFD recommends entities to:

  • assess the materiality of climate-related risks;
  • identify and define a range of scenarios;
  • evaluate the potential effects on the entity’s strategic and financial position under each of the defined scenarios; and
  • identify applicable, realistic decisions to manage the identified risks and opportunities (TCFD Recommendations, pages 25-30). 

Disclosure

Principle 7: Banks should ensure their internal reporting systems are capable of monitoring material climate-related financial risks and producing timely information to ensure effective board and senior management decision-making.

 

APRA encourages entities to consider whether additional, voluntary disclosures could be beneficial in enhancing transparency and giving confidence to the wider market in the entity’s approach to measuring and managing climate-related risks.   While APRA highlighted that best practice would be for APRA regulated entities to make climate-related disclosures in line with the TCFD recommendations, it did not go as far as mandating this since this would be outside the scope of CPG 229.

The TCFD is centred upon disclosure around the following key areas:

  • governance;
  • strategy;
  • risk management; and
  • metrics and targets.

Capital and liquidity adequacy

Principle 5: Banks should identify, quantify and incorporate climate-related financial risks into their internal capital and liquidity adequacy assessment processes.

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Principles for the supervision of climate-related financial risks

Principle 13: Supervisors should determine that banks’ incorporation of material climate-related financial risks into their business strategies, corporate governance and internal control frameworks is sound and comprehensive.

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Principle 14: Supervisors should determine that banks can adequately identify, monitor and manage all material climate-related financial risks as part of their assessments of banks’ risk appetite and risk management frameworks.

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Principle 15: Supervisors should determine that banks comprehensively identify and assess the impact of climate-related risk drivers on their risk profile and ensure that material climate-related financial risks are adequately considered in their management of credit, market, liquidity, operational, and other types of risk.

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Principle 16: Supervisors should adopt a range of techniques when conducting supervisory assessments of supervised banks’ management of climate-related financial risks.

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Principle 17: Supervisors should ensure they have adequate resources and capacity to effectively assess supervised banks’ management of climate-related financial risks.

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Principle 18: Supervisors should consider using climate-related risk scenario analysis, including stress testing, to identify relevant risk factors, size portfolio exposures, identify data gaps and inform the adequacy of risk management approaches.

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