How climate change is impacting the risk profiles of financial institutions

This article was produced in collaboration with Insurance POST

We take a look, from both an Australia and UK perspective, at how board-level considerations of climate change must shift, and the potential consequences if they do not.

While awareness of climate change has, previously, simply provided an environmentally conscious image for corporations, the perceived role of financial institutions in averting the course of climate change is coming to the forefront of the public’s agenda, perhaps hastened by the recent ‘Rebellion Extinction’ protests across major UK cities, or the ‘yellow vest’ protests in France.

Perception worldwide is shifting from the sectors directly linked to fossil fuels and carbon emissions, to a recognition that climate related risks affect all sectors, including the financial industry. But what does this really mean for those at the helm of financial institutions? How are board-level considerations of climate change changing and how must they change, and what are the potential consequences if they do not.

What has changed?

The global finance community appears to accept that financial risks from climate change fall into two primary risk factors: physical risk factors and transitional risk factors.

Physical risk factors include the financial consequences flowing from specific weather events such as heatwaves, floods and wildfires, plus longer-term shifts in climate such as a sea level rise and rising temperatures. This could include financial losses flowing directly from property or infrastructure damage with knock-on effects on asset values and creditworthiness of prospective borrowers.

Transition risk factors are the process of adjustment towards a low carbon economy, such as revaluation in assets due to policy changes or tighter financial conditions.

According to the British Prudential Regulation Authority’s supervisory statement Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change, each of the above may “manifest, for example, as increased underwriting, reserving, credit or market risk for firms”. Additional liability risks may arise from parties that have suffered loss or damage from physical or transition risk factors seeking to recover losses from those they hold responsible. No doubt, this will be an area companies and organisations will seek to insure against going forward.

These risks are difficult to define in terms of potential magnitude and timing. As such, horizon planning may not be sufficient to ward off or protect against climate change risk factors.

The PRA, which has expressed its support of the British government’s recently released Green Finance Strategy, has also made clear that it expects the boards of financial institutions to have considered these matters up to the highest level of executive management.

Similarly, the Australian Securities and Investments Commission RG247 states that it is likely to be misleading to discuss prospects for future financial years without referring to the material business risks such as climate risk.

The Australian Prudential Authority in its Awareness to Action report dated March 2019 also indicated it would be enhancing its supervision activities on regulated entities based on addressing climate change risks which they label ‘material, foreseeable and actionable’.

What must directors do?

As a result, directors and officers of listed companies need to understand and continually reassess existing and emerging risks that may affect the company’s business. It is incumbent on listed companies to have strong and effective corporate governance to help identify, assess and manage material risks including climate change risk.

In the UK, boards will be expected to evidence how they monitor and manage financial risks from climate change, beyond consideration of historical data, to include stress testing and future trends in catastrophe modelling. The PRA intends to embed such matters into its existing supervisory framework.

In Australia, under the Corporations Act 2001, companies must disclose material business risks affecting future prospects in an operating and financial review in a directors report and any company prospectus. In addition, section 180 imposes a general duty of care and diligence on directors and officers.

Noel Hutley SC and Sebastian Hartford-Davis’ landmark legal opinion published on 7 October 2016, together with their recent supplementary opinion published on 26 March 2019, has notably interpreted this provision as extending to a duty to consider and respond to climate change risks.

This interpretation has emerged in recent years in circumstances where evidence on causation before a Court, connecting the actions (or inaction) of directors to damages and losses resulting from climate change, is becoming more persuasive.

A recent rejection by the NSW Land and Environment Court on the development of the Rocky Hill Coal Mine Project came to a finding that there was a causal link between the project’s potential greenhouse gas emissions and detrimental climate change impacts.

It is apparent that evidence relating to climate change has been reinforced by scientific advances proving the foreseeable impacts and causes of climate change, together with heightened policy considerations of climate change as a global crisis.

And if they fail to act?

Across both jurisdictions, failure to acknowledge or prepare for these changing risk factors could result in: solvency issues (for example, if significant assets are focused in a particular area which is affected by either physical or transition risks); or regulatory intervention and penalties.

Further, there is potential for claims to be made against public companies and their directors and officers for failure to properly disclose climate change risks to the market; failure to assess properly, and take adequate action to mitigate, climate change risks; and failure to appropriately value a company’s assets and investments,
taking into account those risks.

Such action has already been seen in Australia, including Federal Court proceedings against the Commonwealth Bank of Australia by two of its shareholders in 2017. Those proceedings alleged a failure to adequately disclose the risk that climate change posed to its financial position in its 2016 annual report. Ultimately, the proceedings were discontinued following the CBA’s acknowledgment that climate change risk is a significant risk to the bank’s operations. However, this is illustrative of the disclosure requirements and the type of claim that we expect to see more of in the future.

Preparing for and adopting strategies

Preparing for and adopting strategies to mitigate against climate change is no longer solely for the environmentally, or at least image, conscious. It is clear that governments and regulators – as evidenced by the position taken in both the UK and Australia – are taking active steps to ensure firms and their officers place climate change and green finance firmly on the agenda.

Climate change risks were once considered to be an emerging risk and something that was discussed in a general way. It is now very clear that climate change risks are real and the consequences of not taking the risks seriously will be significant and potentially devastating, not only to the planet, but to ill-informed and unprepared corporations, organisations, and those at the helm.

This article was originally published on Insurance POST.

Related item: Getting to grips with global warming

Read more items in London Market Brief - October 2019

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