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Australian Prudential Regulation Authority Indicates the Time for Institutions to Address Climate Risks is “Now”

On February 24, 2020, the Australian Prudential Regulation Authority (“APRA”) published a letter outlining plans to establish clearer guidance on expectations for financial institutions in assessing and managing climate risks…

While the specific contents of the guidance remain uncertain, APRA’s letter makes clear that it is concerned with climate-related vulnerability. APRA already views businesses as obligated to consider climate issues when stress testing and therefore it has indicated that the guidance is not intended to create any new requirements or dictate any particular outcomes. Instead, APRA seeks to clarify expectations under existing regulations and make sure climate risks are “actively considered” in the institutions’ decision making process.

Climate change has weighed substantially on Australians’ minds in recent years, particularly with the devastating bushfires that the country experienced in January 2020. These bushfires killed 33 people and destroyed approximately 27.2 million acres of bush, forest and parks, which likely accelerated the perceived urgency of analyzing readiness for various climate-related, or climate-exacerbated, business interruption risks.

General Stress Testing Requirements

From 2018 to 2019, APRA conducted an assessment of the stress testing capabilities of authorized deposit-taking institutions (“ADIs”) in the country, with a focus on governance and scenario development. APRA concluded that institutions with formal governance structures, clear chains of command and accountability were best placed to obtain broader participation across the organization in their stress testing activities.

Following this assessment, APRA announced the need to broaden such tests to formally incorporate climate risks and offered additional “better practice” examples learned from the general stress testing assessment findings. These included:

  • Having a formalized enterprise-wide stress testing framework with clear line of oversight, objectives and requirements; structured roles and responsibilities; and policies and procedures to support the end-to-end stress testing process;
  • Adhering to a schedule for stress testing processes and integrating them with broad engagement across the organization;
  • Having a structured, repeatable scenario development process with effective consultation, review, and challenge mechanisms;
  • Seeking inputs and challenges to the scenarios from across the organization, including from lines of business;
  • Properly justifying and documenting assumptions and limitations of scenarios;
  • Incorporating a range of scenarios with varying degrees of severity; and
  • Reporting on the stress testing results in a way that is detailed but understandable (including scenario narrative, scenario selection rationale, key assumptions and limitations, mitigating actions, and stress test results (before and after applicable mitigating actions)).

Climate Stress Testing

APRA is still developing specific guidance on how to perform climate-related stress testing. APRA plans to develop its climate-focused financial risk assessment this year so that it will be ready for implementation by ADIs in 2021. This assessment is expected to cover both physical impacts, such as extreme weather events, as well as risks that may arise from a global transition to a low-carbon economy. Given APRA’s summary of its general stress-testing assessment mere days before it published the letter on climate-specific measures, it is likely that the climate-specific assessment will similarly focus on governance and scenario analysis, and continue encouraging use of stress testing to inform ADIs’ forward-looking capital and risk management decisions. APRA has also said it will provide updates to environmental, social and governance (“ESG”) investment guidance.

Nevertheless, APRA stated that entities should be proactive in taking steps to assess and mitigate climate change risks and not delay action until further guidance or scenario analysis from APRA is released. APRA has therefore encouraged entities to adopt voluntary frameworks, particularly the Task Force on Climate-related Financial Disclosures (“TCFD”) recommendations. Despite this encouragement of voluntary disclosure frameworks, it is not clear whether APRA will mandate the results of its climate-focused stress testing be publicly disclosed.

Conclusion

APRA’s recent publications highlight its increased focus on climate resilience. APRA does not view climate stress testing as a new requirement but instead as a part of financial institutions’ existing responsibilities. As with APRA’s earlier general stress-testing assessment, Australian financial institutions will likely receive additional guidance and “better practice” insights from APRA, and APRA plans to incorporate updates into existing investment guidelines and standards for ESG considerations. However, even before such guidance and assessments are complete, APRA expects regulated institutions to take action to identify and mitigate potential risks from climate change without delay.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.