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MinterEllison Alert | Bank of England eyeballs the financial sector on climate risk

Sarah Barker (Special Counsel, Melbourne) and Maged Girgis (Partner, Sydney) analyse the impact of recent regulatory developments on climate change risk management and disclosure for Australian financial services sector participants.

2017 – a step-change in climate risk integration and disclosure?

Even before we have reached its mid-point, 2017 is shaping up as a watershed year for the management and disclosure of financial risks associated with climate change. The first 6 months of this year have seen the following significant developments:

  • In January, the World Economic Forum’s annual Global Risks Report rated four risks associated with climate change (‘extreme weather events’, ‘man-made environmental disasters’, ‘natural disasters and ‘a failure of climate change mitigation and adaptation’) within the top 10 risks to the global economy (see here).
  • In February, the Australian Prudential Regulation Authority (APRA) signalled a significant shift in its position on the relevance of climate change risk to the financial sector. In a speech entitled 'Australia's New Horizon: Climate Change Challenges & Prudential Risk', APRA Board Member Geoff Summerhayes made clear that all APRA-regulated entities must recognise that climate change has evolved from a ‘non-financial’ issue to one that presents foreseeable and material financial risks. Moreover, Mr Summerhayes emphasised that a failure to do so may expose directors of asset owners, asset managers, banks and insurers to a claim they have breached their duties (see our Alert here).
  • In March, the world’s largest investor, BlackRock (with assets under management of US$5.1 trillion) issued its 2017-2018 Engagement Priorities - including climate risk disclosure in accordance with the Recommendations of the G20 Financial Stability Board's Bloomberg Taskforce on Climate-related Financial Disclosures(draft recommendations here, with the final recommendations to be presented to the G20 Summit in Hamburg, Germany in July). This was followed by specific guidance on BlackRock's intended engagement with investee companies on climate risk, including a clear warning that it will vote against management – and the re-election of directors - if they fail to constructively engage with this issue (see our Alert here).
  • In April, the Australian Senate Economics References Committee issued its report of the Inquiry into Carbon Risk Disclosure in Australia (‘Carbon Risk: A Burning Issue’). The report included strong recommendations that both the Australian Securities & Investments Commission and ASX provide further guidance to corporations and their directors on the disclosure of the financial risks associated with climate change (here).
  • In May, the majority of shareholders in the world’s largest listed energy corporation, ExxonMobil, voted against management to instead support a resolution requiring the company to assess and disclose the risk to its financial performance and prospects associated with climate change (see for example the Proxy Vote Bulletin issued by BlackRock here).
  • And now, in June, the Bank of England Prudential Regulation Authority has released a document entitled ‘The Bank of England Response to Climate Change’ (here).

While each of these developments are significant in their own right, the report issued by the Bank of England Prudential Regulation Authority in June is particularly noteworthy.

Bank of England Prudential Regulation Authority announces examination of banking sector climate risk exposures

Following its seminal report into the Impact of Climate Change on the Insurance Sector in September 2015 (here), the Bank of England Prudential Regulation Authority has now served notice of its intention to examine the impacts of climate change on all financial sector participants, and to financial stability more broadly. In a report entitled ‘The Bank of England Response to Climate Change’ (the Report) the Bank emphasized two primary channels by which climate change may impact upon monetary and financial stability:

  • Physical risks – climate and weather-related events, such as droughts, floods and storms, and sea-level rise. This includes both the direct impacts of such events, and secondary consequences such as the disruption of global supply chains. The Bank warned that these impacts may undermine financial stability, both directly and indirectly – from higher insurance claims, portfolio losses, sentiment shocks and defaults on loans, through to system-wide impacts such as economic disruption, lower productivity, and increasing sovereign default risk.
  • Economic transition risks - are the financial risks which can result from the process of adjustment towards a lower-carbon economy. The Bank cautioned that changes in climate policy, technology or market sentiment could prompt a reassessment of the value of a large range of assets, and indeed cause sharp changes in valuations (or ‘stranded assets’). The speed at which such re-pricing occurs is uncertain but could impact on financial stability via changes to the value of investment portfolios or bank balance sheets through reduced collateral values, or by affecting business models of borrowers. The financial risk from an abrupt transition to a lower-carbon economy may increase if portfolios are not aligned with climate targets. The Bank warned that this implies ‘the reallocation of tens of trillions of dollars of investments’.

The Report also noted the Bank's continued monitoring of a second-order risk – that of litigation arising from the failure to effectively manage these physical and economic transition risks.

The Report articulated the Bank’s dual-track response to these risks:

  • first, by firm-level research and engagement in the insurance and banking sectors; and
  • second, by working to enhance financial system resilience by supporting an orderly market transition to a low carbon economy. In doing so, the Bank is giving specific emphasis to the Recommendations of the Michael Bloomberg-led taskforce of the G20 Financial Stability Board: the Taskforce on Climate-related Financial Disclosures (above).

How do the cautions from the Bank of England’s report resonate in Australia?

The Bank of England’s report contains prescient warnings for Australian financial sector participants.

First, ‘stranded asset’ risk exposure is particularly relevant to an economy whose stock exchange is dominated by companies in the mining, energy and financial services sectors. This was brought into sharp focus by a recent report by S&P Dow Jones, Barometer of Financial Markets’ Carbon Efficiency (here), that rated the ASX50 as having the greatest stranded asset risk exposure of any major international share index. This comes at a time when Australian banks are already facing pressure on their long-term credit ratings, with agency concerns over the susceptibility of their credit profiles to adverse shock.

Secondly, the Bank of England’s report follows an explicit statement of expectation by our own prudential regulator, APRA, that the integration and disclosure of the financial risks associated with climate change is necessary to discharge the duty of due care and diligence by directors of financial services corporations (above).

For these reasons alone, any corporation in the Australian financial services sector should consider the Bank of England’s report as part of its broader analysis of climate risks on its financial performance and prospects.

So what to do? Leading international expertise and next steps

So what do these developments mean for the corporate governance, risk management and disclosure in the Australian financial services sector?

In short, it is now beyond doubt that climate change cannot be consigned to a corporate compliance, public relations or ‘niche social interest’ silo. Its impact on balance sheet items and forward-looking risk and strategy must be reconsidered, in an integrated manner, in the light of contemporary economic realities. This is critical not only for directors, who sign-off on both financial accounts and narrative managerial statements, but accounting and risk advisors.

MinterEllison has been at the forefront of thought leadership in this area and is unique amongst its peers in viewing climate change through a corporations and securities law lens (rather than an 'environmental' lens), for a number of years. Insights from investment market partners, and our work with institutions ranging from the Bank of England and European Union to the UNEP Financial Initiative have provided our financial services clients with tools to efficiently integrate climate risk management into corporate governance and strategy. It is expertise that we would be pleased to share as you consider the practical implications of these developments for your organisation’s corporate governance and risk management.

Please do not hesitate to contact Sarah Barker (Special Counsel, Corporate, Melbourne) or Maged Girgis (Partner, Financial Services, Sydney) (below) if we can assist.