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Climate-related risk highlighted in Reserve Bank Act review

July 2019 - Finance. Legal Developments by Bell Gully.

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The role of the Reserve Bank in assessing and responding to the risks climate change poses to financial stability features in the current consultation on New Zealand's financial policy framework. Inclusion of climate change as part of the wide-ranging review of the Reserve Bank Act is further evidence of the growing trend towards climate-related risk reporting and disclosures.

In February this year Bell Gully released The Big Picture: Climate Change report, setting out why New Zealand businesses must start to plan for the consequences of climate change. The report addressed a range of practical implications of the transition to a low-emissions economy, including the rising price of carbon, changes to the Resource Management Act 1991, shifts in the forestry industry, and climate change litigation.

The Big Picture report also discussed climate change-related disclosures, which is an important and quickly growing dimension of the climate change regulatory landscape. This update highlights a number of recent developments in New Zealand and internationally to keep you across the emerging best practice in this area.

Last year the Government announced a phased review of the Reserve Bank of New Zealand Act 1989 (the Act) to create a modern monetary and financial policy framework (the Review). It's a comprehensive review of the legislation and includes consideration of the Reserve Bank's role and objectives, including its tools, powers, and approach.

Last week the Minister of Finance announced the second round of consultation on the Review. As discussed in a recent article, Treasury released both a set of in-principle decisions on the first round of consultation and the topics for Phase 2 of the review. Given the large number of topics and broad scope of this consultation, it's vital to highlight the inclusion of climate-related risk in the Phase 2 Terms of Reference.

The Terms of Reference specifically provide that “The Review will also include consideration of monitoring and managing the risk that climate change poses to New Zealand's financial stability, in light of the recommendations of the Task Force on Climate-related Financial Disclosures."

This mirrors important developments in this area in the UK. The Bank of England Prudential Regulation Authority (PRA) has recently undertaken a consultation on climate risk, and in April published a new Supervisory Statement that sets out its expectations on how banks and insurers should manage the financial risks from climate change. These developments in the UK are likely an indication of new regulatory settings on the horizon domestically.

The Reserve Bank's role and climate change risks

The Reserve Bank has already indicated its strong interest in climate change, which is only to be expected given that understanding and managing risk is critical to many of its core functions. The Reserve Bank's November 2018 Financial Stability Report included a section on both the physical and transitional impacts of climate change on New Zealand's financial system.

The Financial Stability Report also highlighted the critical role of financial sector participants in assessing their own current and future exposures to these risks, while also noting the Reserve Bank's important function in monitoring climate risks across the system and incorporating them within regulatory frameworks in order to drive appropriate disclosures.

In explaining why the Review is considering the Reserve Bank's role in addressing the risks presented by climate change, reference is made to the different types of financial risks posed by climate change:

  • Physical risks related to the effects of climate change – climate and weather-related events can lower the value of certain assets, such as beachfront homes at risk from sea-level rise, and farming assets exposed to the effects of droughts and floods. These risks have implications for bank lending and insurance pricing and availability.

  • Transition risks associated with the shift to a lower-carbon economy – changes in climate policy, technology or market sentiment could prompt a reassessment of the value of a range of assets, such as fossil fuel resources or high-emission agriculture.

The new PRA Supervisory Statement mentions a third category of risk: “Liability risks", which arise from parties who have suffered loss or damage from physical or transition risk factors seeking to recover losses from those they hold responsible.

While the Reserve Bank goes on to note the risks of climate change have been traditionally seen as a government responsibility, there is growing recognition that financial system participants, including central banks and financial regulators, have a role in mitigating the financial risks of climate change.

Climate-related disclosures

The Task Force on Climate-Related Financial Disclosures (TCFD) was set up in 2015 by the G20's Financial Stability Board to develop voluntary, consistent standards for climate-related risk disclosures. The goal of this new framework is to improve the ability of investors, lenders, insurers, and other stakeholders to assess and price climate-related risk and opportunities.

 The TCFD has four key recommendations:​

  • Governance: Disclose the organisation's governance around climate-related risks and opportunities.

  • Strategy: Disclose the actual and potential impacts of climate-related risks and opportunities on the organisation's businesses, strategy, and financial planning where such information is material.

  • Risk management: Disclose how the organisation identifies, assesses, and manages climate-related risks.

  • Metrics and targets: Disclose the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material.

These recommendations are gaining increasing uptake across jurisdictions and we have already had recognition of the TCFD recommendations in New Zealand, notably in NZX's Environmental, Social and Governance Guidance Note. The updated NZX Corporate Governance Code also recommends that an issuer “should provide non-financial disclosure at least annually, including considering material exposure to environmental, economic and social sustainability risks and other key risks."

The TCFD recommendations have been similarly recognised in Australia. The ASX Corporate Governance Council updated its Corporate Governance Principles and Recommendations in February 2019 to include an amendment to “encourage entities to consider whether they have a material exposure to climate change risk" by reference to the TCFD recommendations.

Yet mandatory climate-related disclosures do not feature in the Zero Carbon Bill (which is currently before Select Committee). The Explanatory Note to the Bill notes that proposals for climate-related financial disclosures have “been ruled out at this time, as those sorts of reporting requirements for the private sector are being progressed outside the Bill." However, consideration of the role of climate risk in financial stability as part of the Review could be a sign that we may see the introduction of some form of climate reporting through a different avenue.

An emerging international trend

As discussed in our Big Picture Report on climate change, we have already seen building momentum towards disclosure of climate change-related risks, both overseas and in New Zealand. The consideration of climate risk in the Review of the Act is another example of the international trend towards climate-related financial disclosures. There have been a number of other important developments so far this year.

In February 2019, in a speech to the Sustainable Insurance Forum, the Executive Board Member of the Australian Prudential Regulation Authority (APRA) Geoff Summerhayes recognised that “regulators' current stance of merely encouraging climate-risk disclosure will inevitably harden towards making such disclosure mandatory." In March, APRA published an Information Paper Climate change: Awareness to action where it said it “will be embedding the assessment of climate risk into its ongoing supervisory activities". The Information Paper also noted how over recent years APRA has highlighted the financial nature of climate change risks to its regulated entities and advised that these risks are “material, foreseeable and actionable now".

This view was only reinforced in a speech by the Deputy Governor of the Reserve Bank of Australia Guy Debelle in March where he noted that the physical and transitional risks of climate change “could precipitate sharp adjustments in asset prices, which would have consequences for financial stability" and that “financial stability will be better served by an orderly transition rather than an abrupt disorderly one".

In March, the United Kingdom Financial Conduct Authority held the first meeting of the Climate Financial Risk Forum. The objective of the Forum is to build capacity and share best practice across financial regulators and industry to advance financial sector responses to the risks from climate change. Last month the European Commission also published further guidelines on non-financial reporting, specific to climate-related information.

Most relevantly, we may get a steer on the possible outcomes of the Review by looking to the work of the PRA in the UK. In April the PRA published Supervisory Statement SS3/19: Enhancing banks' and insurers' approaches to managing the financial risks from climate change.

The Supervisory Statement sets out the PRA's expectations relating to how banks and insurers:

  • embed the consideration of the financial risks from climate change in their governance arrangements;

  • incorporate the financial risks from climate change into existing financial risk management practice;

  • use (long term) scenario analysis to inform strategy setting and risk assessment and identification; and

  • develop an approach to disclosure on the financial risks from climate change.

Some of the PRA's more specific expectations are that banks and insurers:

  • have clear roles and responsibilities for the board in managing the financial risks from climate change;

  • understand the financial risks from climate change and how they will affect their business model;

  • develop and maintain an appropriate approach to disclosure, reflective of the distinctive elements of the financial risks from climate change and recognise the increasing possibility that disclosure will be mandated in more jurisdictions, and prepare accordingly.

The Reserve Bank and Treasury will no doubt be looking to these UK developments as part of the current review. These expectations are a reflection of emerging international best practice and are a direct parallel to the consultation on the role of the Reserve Bank in monitoring and managing the risk that climate change poses to New Zealand's financial stability.

These changing expectations are examples of the shifts in behaviour that may be required as part of creating a modern monetary and financial policy framework, particularly in the context of a legislated target for net-zero emissions by 2050 (as is the objective of the Zero Carbon Bill).

Submissions on the Phase 2 consultation on review of the Reserve Bank Act close on 16 August 2019.

If you have any questions on the Phase 2 consultation and how it relates to climate-related risk, or would like assistance on preparing a submission please contact one of our climate change team or your usual Bell Gully adviser.​