30 June 2021

APRA draft guidance on managing the financial risks of climate change CPG229

This article was written by Tim Bednall, Miriam Kleiner and Pei Xuan Liu

Climate risk and disclosure have become a shared focus of Australian financial regulatory bodies. In 2021, ASIC has signalled that disclosing and managing climate-related risk is a key director responsibility and APRA has included climate risk initiatives as supervision priorities for 2021. As part of this focus, APRA has released draft Prudential Practice Guide CPG 229 Climate Change Financial Risks (“CPG 229”) for consultation until 31 July 2021. Subject to feedback, the final CPG 229 is expected to be released before the end of 2021.

CPG 229 is APRA’s first cross-industry prudential practice guide on the management of climate-related financial risks and was developed in consultation with domestic and international peer regulators.

Importantly, CPG 229 does not impose new requirements in relation to climate risks and does not, of itself, create legally enforceable requirements; rather, it supports compliance with APRA’s existing risk management and governance requirements and is designed to provide guidance on APRA’s view of sound practice in key areas - governance, risk management, scenario analysis and disclosure.

Under CPG 229, ‘climate risks’ refers to the financial risks arising from climate change, including:

  • physical risks – risks related to long-term changes in climate and changes to the frequency and magnitude of extreme weather events, which can cause direct damage to assets or property, changes to income and costs, and changes to the cost and availability of insurance.
  • transition risks – risks related to changes in domestic and international policy, technological innovation, social adaptation and market changes, which can result in changes to costs, income and profits, investment preferences and asset viability.
  • liability risks – risks stemming from the potential for litigation if institutions and boards do not adequately consider or respond to the impacts of climate change.

APRA’s key message is that APRA-regulated institutions should take a strategic and risk-based approach to the management of the risks and opportunities arising from climate change. Climate risks can and should be managed within an institution’s broader risk management framework but APRA-regulated institutions should be live to the unique elements of climate risks, which necessitate a strategic approach to their management. In particular, institutions should understand the interaction between climate risks and their business activities and the compounding effect that climate risks may have on an institution’s other risks, including credit risk, market risk, operational risk, underwriting risk, liquidity risk and reputational risk.

The twin themes throughout CPG 229 are:

  • firstly, APRA acknowledges that APRA-regulated institutions have the flexibility to configure their approaches to climate risk management in a manner best suited to achieving its business objectives (subject to meeting the requirements of the prudential standards) – whether the practices outlined in CPG 229 are relevant may vary depending upon the size, business mix and complexity of the institution. In particular, CPG 229 highlights that risk management and the use of scenario analysis and stress testing should be proportionate to the institution’s size, business mix and complexity of its business operations.
  • secondly, the framework from the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) is reflected in CPG 229 and provides a sound basis for scenario selection and analysis and disclosing information that is useful for an institution’s stakeholders.

The following table highlights some of APRA’s key observations and suggestions across key areas.

Area

Key observations and suggestions by APRA

Governance

APRA considers that:

▪ climate risks can and should be managed within an institution’s overall business strategy and risk appetite. A board should be able to evidence its ongoing oversight of these risks when they are deemed to be material. [1]

▪ as with the management of other risks, if the board has delegated certain functions of the management of climate risks, the board should maintain mechanisms for monitoring the exercise of its delegated authority. [2] 

▪ in overseeing the management of climate risks, a prudent board would: [3] 

o ensure an appropriate understanding of, and opportunity to discuss, climate risk at the board and sub-committee levels (including appropriate training for board members);

o set clear roles and responsibilities of senior management;

o hold senior management to account for its responsibilities in the management of climate risks;

o re-evaluate the risks, opportunities and accountabilities arising from climate change on a periodic basis, and consider these risks and opportunities in approving the institution’s strategies and business plans;

o take both a short- and long-term view (which may be beyond the institution’s regular business planning horizon) when assessing the impact of climate risks and opportunities;

o where climate risks are found to be material, ensure that the institution’s risk appetite framework incorporates the risk exposure limits and thresholds for the financial risks that the institution is willing to bear.

Risk management

A prudent APRA-regulated institution would:

▪ consider climate risks within its existing framework, including the board-approved risk appetite statement, risk management strategy and business plan. [4]

▪ evidence the management of climate risks within its written risk management policies, management information, and board risk reports [5] and ensure that policies and procedures include a clear articulation of the respective roles and responsibilities of business lines and risk functions (i.e. Line 1 and Line 2 activities) in relation to managing climate risks. [6] 

▪ specifically focus on risk identification, risk monitoring, risk management and risk reporting (APRA provides detailed guidance on good practice in each area in CPG 229).

Scenario analysis

A prudent APRA-regulated institution would:

▪ develop capabilities in climate risk scenario analysis and stress testing;

▪ alternatively, have access to external scenario analysis and stress testing capabilities, to inform their risk identification in the short and long term; and [7]

▪ maintain appropriate documentation of the process and results of its climate risk scenario analysis and stress testing and communicate material results to the institution’s board and senior management. [8]

APRA acknowledges that climate risk scenario analysis is a developing area and that not all institutions will have the capability to undertake best practice analysis. In developing their capability, institutions should consider leading practice, which involves (amongst other things): [9]

▪ A short-term assessment of current exposures to climate risks, in line with current business planning cycles.

▪ A long-term assessment of future exposures based on a range of different climate-related scenarios, potentially extending to 2050 or beyond. Key scenarios include:

o global average temperatures continuing to rise in the absence of mitigating actions and policies (for example, temperature increases in excess of 4 degrees Celsius by 2100);

o global average temperatures rising by 2 degrees Celsius or less, consistent with the Paris Agreement;

o an orderly transition to a lower-emissions economy (minimising both physical and transition risks); and

o a disorderly transition to a lower-emissions economy (leading to an increase in acute transition risks).

▪ Incorporating both qualitative and quantitative factors into the scenarios and assessing both physical and transition risks within each scenario.

▪ Seeking input from external experts, while maintaining appropriate internal knowledge and oversight.

▪ Measuring the impact of climate risks on a range of business obligations and considerations, including solvency, liquidity, and the ability to meet obligations to depositors, policyholders and superannuation fund members.

Disclosure

APRA considers that:

▪ lack of absolute certainty in relation to climate risks’ future impacts should not be considered a reason to avoid disclosure of exposure to those risks. [10]

▪ a prudent institution would consider whether additional, voluntary disclosures beyond any statutory or regulatory requirements, could be beneficial to the institution by enhancing transparency and giving confidence to the wider market in the institution’s approach to measuring and managing climate risks. [11]

▪ a prudent institution would continually look to evolve its own disclosure practices, and to regularly review disclosures for comprehensiveness, relevance and clarity, to ensure it is well-prepared to respond to evolving expectations in relation to climate-related disclosures. [12]

[1] Draft CPG 229, paragraph 14.

[2] Draft CPG 229, paragraph 15.

[3] Draft CPG 229, paragraph 16.

[4] Draft CPG 229, paragraph 18.

[5] Draft CPG 229, paragraph 20.

[6] Draft CPG 229, paragraph 21.

[7] Draft CPG 229, paragraph 36.

[8] Draft CPG 229, paragraph 44.

[9] Draft CPG 229, paragraph 40.

[10] Draft CPG 229, paragraph 46.

[11] Draft CPG 229, paragraph 47.

[12] Draft CPG 229, paragraph 49.

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