We explore the regulatory focus on climate risk, implications for financial reporting and how this affects the financial services sector to address climate related financial risks.
Living in a new world
Australia has been living through the effects of climate change over the past twelve months. Following the drought, we experienced the devastating bushfires and the onslaught of the flash floods. These event driven physical risks are just one aspect of climate risk. The Australian economy is also subject to the climate risks associated with transitioning to a lower carbon economy, which will bring extensive policy, legal, technology and market changes.
The past year has also seen a significant shift in Australia’s collective awareness of climate change. There has also been a ratcheting up of the regulatory and industry response, matching the increased community focus. As the intensity and frequency of the physical impacts of global heating continue to increase this growth in the importance of climate change is also likely to accelerate in future years.
With major financial institutions banking and insuring the majority of Australian businesses and consumers, climate change also plays a significant impact on these institutions. For this reason, climate change is therefore of strategic importance to their futures too.
The regulatory focus
Regulators have been increasingly concerned with climate risks remaining unidentified on the balance sheets of regulated entities. Regulators have therefore focused on communicating guidance to improve the ability of corporates to identify climate related risks and opportunities, to formulate a response and present appropriate disclosures to the capital markets. In this regard the implementation of the Taskforce on Climate related Financial Disclosures (TCFD) recommendations are critically important, with both ASIC and APRA publishing further direction on climate related financial risks in recent times.
ASIC Report 593 Climate risk disclosure by Australia’s listed companies sets out ASIC’s high-level findings and recommendations for listed companies following their review of climate risk disclosure practices in the market. ASIC found more could be done to improve consistency in disclosures across listed companies, with very limited climate risk disclosure outside the Top 200 companies.
Climate change is a foreseeable risk facing many listed companies in the Australian market in a range of different industries. Directors and officers of listed companies need to understand and continually reassess existing and emerging risks (including climate risk) that may affect the company’s business – for better or for worse. Climate risk disclosure practices are still evolving, not only in Australia but also globally. We intend to monitor market practice as it continues to evolve and develop in this area.
Climate related financial risks will continue to be a focus of APRA’s efforts to increase resilience across the financial services industry – giving more attention to understanding these risks and their subsequent impacts on its prudentially regulated entities and the economy more broadly. This focus will include a deeper supervisory assessment of each entity that participated in APRA’s 2018 climate change survey.
APRA is also developing a climate change financial risk prudential practice guide (PPG), which is being informed by its engagement with other regulators domestically and internationally. The PPG won’t impose new obligations on institutions, but will be designed to assist entities comply with their existing obligations for managing risk, such as those found in CPS 220 Risk Management. The PPG will address the prudent management of climate change financial risks, will align with the recommendations of the TCFD and cover governance, strategy, risk management, metrics and disclosure.
In January 2020, APRA announced its 2020 priorities which included more closely assessing institutions’ capability to deal with emerging and accelerating risks, such as climate change. APRA (in collaboration with ASIC and the RBA via the Council of Financial Regulators, as well as the CSIRO and Bureau of Meteorology) announced they would undertake climate change financial risk vulnerability assessments of large ADIs. These assessments will involve entities estimating the impact of a changing climate on their balance sheets as well as risks that may eventuate from the transition to a low-carbon economy. Whilst APRA recently adapted its 2020 priorities to prioritise its response to COVID-19, it did note these were only temporarily suspended until at least 30 September.
We are not alone
The focus by Australian regulators on climate related financial risk is consistent with developments overseas. In the UK, the Bank of England’s proposal to test the resilience of the UK’s financial system for a range of climate-linked financial risks involves the extension of its existing annual stress test for the seven largest lenders including Barclays, HSBC and Lloyds Banking Group. This extension broadens the scope of testing to capture the UK’s largest lenders and insurers and scrutinise their balance sheets to consider how they would cope with increasingly frequent and severe weather events, as well as the transitional impacts of climate change, including fire sales of brown assets. Similar to APRA, and in response to COVID-19, the Bank of England also recently announced that it would temporarily cancel the 2020 stress test.
This focus on climate related risk is also shared by other prudential regulators and supervisors around the world. Through the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), Central Banks (including both the RBA and RBNZ) are following the Bank of England’s lead. The NGFS is a network of 34 central banks and financial supervisors focused on accelerating work on climate and environmental financial risk and scaling up green finance.
Implications for reporting
The AASB and AUASB, in their April 2019 Joint Publication Climate-related and other emerging risks disclosures: assessing financial statement materiality using AASB/IASB Practice Statement 2, stated they expect directors, preparers and auditors to consider AASB/IASB Practice Statement 2 Making Materiality Judgments (APS/PS2) when preparing and auditing their financial statements at the half year and year end. APS/PS2 states qualitative external factors and investor expectations may make climate related risks ‘material’ warranting disclosure in the financial statements (rather than just in the annual report as currently happens now), regardless of their numerical impact. This is supported by growing investor statements globally on the importance of climate related risks to their decision making.
The AASB and AUASB’s Joint Publication, which acknowledges the TCFD identified financial sector entities as those that might be indirectly impacted by the effect of climate risk on their clients, recommends:
- preparers of financial statements in accordance with Australian Accounting Standards should consider:
- Whether investors, having indicated the importance of climate related risks in their decision making, could reasonably expect climate related risks to affect the amounts and disclosures in the financial statements; and
- What disclosures about the impact of climate related risks on the assumptions used to prepare the financial statements are material to the financial statements in light of APS/PS2.
- auditors of financial statements should consider:
- Climate related risks as part of their audit planning risk assessment under ASA 315 Identifying and assessing risks of material misstatement through understanding the entity and its environment; and
- Whether climate related risks are relevant for accounting estimates including assumptions to determine fair values and impairment under ASA 540 Auditing accounting estimates and related disclosures.
Implications for the financial services sector
The TCFD was created back in 2017 to assist financial sector entities including banks, insurers, investment entities and asset managers identify exposures to climate risk in their portfolios. Such financial sector entities, in their financial statements, should explain whether and how they have considered climate related risk in their lending and investment decisions, their impairment assessments and how climate related risks have affected other decisions made in relation to the recognition or measurement of items in their financial statements.
In particular, financial sector entities should disclose how climate related risks impacted their loan and investment portfolios including their valuation at balance date under existing accounting standards:
- Under AASB 9 Financial Instruments banks investing in projects or lending money to businesses impacted by climate related risks should consider how the climate related risks affect expected credit losses on these investments and loans. Similar considerations apply to loans to retail and business banking customers affected by droughts, bushfires, floods and other extreme weather events;
- Under AASB 7 Financial Instruments: Disclosures insurers, investment entities (including superfunds) and asset managers holding investments impacted by climate related risks are required to disclose their exposures to such risks, their objectives for managing these risks and changes from the previous period; and
- Under AASB 13 Fair Value Measurement entities recognising assets on their balance sheet at fair value, where their fair value is impacted by climate related risks, are required to disclose key assumptions of how climate related risks are factored into their fair value calculations at balance date.
Resilience in a new climate
Last summer proved to Australians and the world that climate change had arrived. With growing regulatory, community and business focus, it is only a matter of time before Australia, like other nations, transitions to a lower carbon economy.
Today, we already have existing risk management guidance and accounting standards to address climate related financial risks. Tomorrow, as we start this journey, we can become more resilient as a financial services industry and together increase our resilience in a new climate.