APRA calls for stress-testing of climate change risks in regulated entities

The Australian Prudential Regulation Agency (APRA) will emphasise to regulated entities that they should conduct stress testing for “organisational and systemic resilience in the face of adverse shocks” from climate risk.

Speaking to the Insurance Council of Australia Annual Forum in Sydney, Geoff Summerhayes, executive board member, spoke of APRA’s evolving view on climate risks as part of the agency’s “broader approach to prudential risk management and supervision.”

“So what can you expect to see from us,” Summerhayes said in the speech. “Firstly, something you would already be aware of is a greater emphasis on stress testing for organisational and systemic resilience in the face of adverse shocks. It could be the case that, just as we would expect to see more sophisticated scenario-based analysis of climate risks at the firm level, we look at these risks as part of our system-wide stress testing.”

Summerhayes noted in his remarks that his observations on climate-related risks apply not only to insurers but for all APRA-related entities. APRA regulates the prudential standards and practices for banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, private health insurance, friendly societies and most members of the superannuation industry.

Elsewhere in his speech, Summerhayes said that the prevailing wisdom that climate risks are a future problem or a non-financial problem no longer holds true.

“The key point I want to make today, and that APRA wants to be explicit about, is that this is no longer the case,” he said. “Many of these risks are foreseeable, material and actionable now. Climate risks also have potential system-wide implications that APRA and other regulators here and abroad are paying much closer attention to.”

Sarah Barker, special counsel, Minter Ellison Lawyers

Sarah Barker, special counsel, Minter Ellison Lawyers

Sarah Barker, special counsel at Minter Ellison, hailed the remarks by Summerhayes.

“APRA’s stated position reflects the advice we have been providing to our APRA-regulated clients in recent years that the material financial risks and opportunities associated with climate change must be factored into consideration of risk strategy strategic asset allocation and mandates in the same way as any other material financial risk,” she said. “I would expect that the board and trustees of APRA Regulated entities will appreciate the importance of reframing their views on climate risk through the lens suggested by APRA as a matter of priority.”

Summerhayes cited three recent developments that have impacted on the evolution of the impacts of climate risk, and the role that regulators such as APRA have to play: the Paris Agreement, a report by the Financial Stability Board’s Taskforce on Climate-related Financial Disclosures recommending a global, framework for improving a wide spectrum of climate-related disclosures, and the legal analysis, Legal Opinion on Climate Change and Directors Duties from the Centre for Policy Development and the Future Business Council opinion on company directors’ legal obligations to consider the impacts of climate change, authored by barrister Noel Hutley SC.

Barker was the instructing solicitor on the Climate Change and Directors Duties opinion authored by Hutley.

“The opinion found that company directors who fail to properly consider and disclose foreseeable climate-related risks to their business could be held personally liable for breaching their statutory duty of due care and diligence under the Corporations Act,” Summerhayes said. “The author warned it is ‘only a matter of time’ before we see this sort of litigation against a director. I participated in an important roundtable to discuss the implications of the opinion and was struck by how constructively senior company directors, investors and fellow regulators are engaging with these challenges.  In this and other discussions, I have detected a broad appetite for regulators and firms to get much better at this now that the horizon for Australia is in sharp focus.”

Summerhayes defined two risks to insurance companies and other APRA-regulated entities – physical risks and transition risks.

“The general point is that the transition now in train could potentially lead to significant repricing of carbon-intensive resources and activities and reallocation of capital,” he said. “This process will be highly sensitive to changes in regulation, technology, the physical environment and behaviour by investors and institutions – and interrelated perceptions and sentiment about all of the above. Inevitably, even under a sanguine view of how smoothly this transition happens, there will be systemic impacts and implications that have to be carefully monitored.”

Summerhayes gave a blunt warning in the speech.

“[G]iven all the developments I’ve flagged today, if entities’ internal risk management processes are not starting to include climate risk as something that has to be considered – even if risks are ultimately judged to be minimal or manageable – that seems a pretty reasonable indicator there might be something wrong with the process,” he said. “Similarly, if you’re an investor and you’re not already asking questions about how the companies you invest in approach these issues – perhaps you should be.”

The Investor Group on Climate Change (IGCC) welcomed the speech.

“APRA’s comments today bring home the reality that climate change is a major economic force impacting the way we think about risk and opportunity,” said Emma Herd, IGCC CEO. “The work of the FSB Taskforce on Climate-related Financial Disclosure (TCFD) which followed in 2016 reinforced industry and investor appetite for greater clarity on how to price, manage and capitalise on the economic transition being driven by climate change. APRA has now responded and set out clearly their view that Australian companies should be managing climate change and that there are system-wide implications for the Australian economy in how we manage this transition.”

Barker emphasised the importance of Summerhayes’ remarks.

“This represents the next step in visibility of this issue within Australian boardrooms over and above even the significant interest that the Hutley opinion generated late last year,” she said.

 

Rachel Alembakis is the publisher of The Sustainability Report a weekly digital publication that provides reporting into Environmental, Social and Governance (ESG) issues related to companies listed on the Australian Stock Exchange.