Over recent years, the Australian Prudential Regulation Authority (APRA) has taken an active role in ensuring a consistent approach to the assessment and disclosure of climate related financial risk. In April 2021, APRA issued new draft climate risk reporting guidelines, the second phase in its effort to assist banks, lenders, businesses, superfunds and insurers in understanding the implications of climate change to their sectors.
Over the coming months, the five largest Australian banks will conduct Climate Vulnerability Assessments as part of a pilot to help measure climate related risk to financial institutions and the economy. According to APRA’s Design and Instruction Guide this process will have three key objectives:
- Assess the vulnerability of key financial institutions to both physical and transition risks arising from climate change;
- Understand how financial institutions could adjust their business models and implement management actions in response to different scenarios; and
- Improve financial institutions’ climate risk management capabilities.
The first round of Climate Vulnerability Assessments will invariably provide more information and clarity around how banks should be addressing climate change related risks. Further vulnerability assessments are expected to be rolled out across the rest of the banking sector in 2022.
Building on APRA’s draft guidelines
Climate Valuation lists five key points for all Australian banks, mortgage brokers and lenders to consider as they seek to effectively address climate change related risk:
- There’s a clear move from one-off climate risk reporting to ongoing and dynamic oversight. Portfolio churn and the natural turn over of mortgages means that a bank’s risk distribution may change drastically in the coming years. Without ongoing oversight and an integrated risk management approach, a bank may find its climate risk increasing over time as industry peers turn away ‘high risk’ business. As climate science and impact predictions evolve, improved risk models will provide better insights into hazard impacts and geographical exposure. This means lenders should start considering dedicated climate risk governance systems that are part of overall risk management, not siloed in company ESG reporting.
- Climate Risk could favour first movers. Demonstrating an investment in climate risk reporting and mitigation has impacts on your company’s competitive position. As pressure for banks to reveal the extent of climate risk to their books increases, there will be growing incentives to avoid writing new mortgages at risk from climate impacts. As lenders with climate intelligence start to screen out at-risk loan applications, the fraction of at-risk assets in other lenders’ portfolios will increase. Long term, a lender’s portfolio’s position relative to competitors will impact on the favourability of residential mortgage-backed securities (RMBS) and other investment-based products. Those who know their areas of risk and take action to mitigate it will invariably have a competitive advantage over those that do not.
- Inaction on climate change will inevitably bring legal and financial repercussions. Banks and lenders that fail to account for climate change related costs in serviceability and loan to value ratio (LVR) calculations may be in breach of responsible lending practices and could face lawsuits from customers facing financial hardship due to rising insurance premiums and property devaluations. Mortgage customers in high risk zones are facing increasing premiums upwards of 2% to 3% of their property value and in some extreme cases may present default or delinquency risk to the bank. Lenders and banks over-invested in high risk areas may also experience asset value depreciation over time which, left unchecked, may result in negative equity.
- Banks and lenders are encouraged to look beyond reporting and towards innovative products and practices. APRA has signalled that it will soon be requesting companies provide evidence of plans to manage risk that include engaging with customers and counter-parties. This could mean providing financial assistance to customers to adapt to climate change, rewarding those who have invested in resilience and/or implementing policies to limit exposure to high risk sectors. Some banks are already establishing the ability to screen incoming applications as part of the loan origination process. Such a strategy will enable lenders to identify risky properties and develop appropriate support programs for high risk customers.
- Bring in the climate risk expertise you need. The complexity of climate risk management and forward-thinking scenario planning requires specialist knowledge, a skillset that is not often found in-house. Regulatory frameworks and guidelines are emerging at a rapid pace. Globally, only a small amount of specialist organisations have the ability to practically interpret these complex reporting requirements. Finding a solution that meets your organisation’s specific needs and that integrates with existing internal systems can save a great deal of time and money.
Climate Valuation is a company specialising in climate risk to the residential property sector. We provide physical risk analysis to financial institutions to support climate risk reporting and can help APRA regulated entities to fulfil their obligations under the Climate Vulnerability Assessments. Drawing on aspects of the TCFD guidelines as well as other international regulatory frameworks, Climate Valuation’s products and services are designed to support the Australian finance sector as it seeks to effectively address climate-related physical & financial risks to residential assets.
For more information about Climate Valuation’s services for lenders: https://climatevaluation.com/commercial.