The Australian Prudential Regulation Authority (APRA)’s information paper from its first Climate Vulnerability Assessment for the Australian banking sector is an important and welcome exercise in reviewing the vulnerability of the Australian banking sector to climate change that should be read as much for its limitations as its findings. It will be followed by a broader National Climate Risk Assessment by the Department of Climate Change, Energy Environment and Water in the coming year.
The CVA found that climate change could make Australia’s banking sector more vulnerable to future economic downturns – this much is already understood by central banks around the world, including our own. What was less clear from the analysis, was how much climate change would compound and prolong economic downturns in ways far more permanent and structural than ‘cyclical’ analyses typically adopted in downside stress testing approaches.
Each bank undertook an assessment of the physical climate risks present in its residential and business lending portfolios under two scenarios: one, where action to prevent 2 degrees of global warming is delayed until 2030 and then taken rapidly from that year (“Delayed Transition”), the other, a “Current Policies” scenario where limited action is taken and global warming eventual escalates to over 3 degrees above the pre-industrial average. The results are varied and the limitations instructive.
Consider lending to residential property. Climate Valuation’s national assessment of property risk in Australia found 4.5% of addresses are likely to be at high risk from extreme weather and climate change by 2050 under an RCP8.5 scenario. It is not clear from APRA’s information paper whether comparable results were uncovered by the CVA.
What is clear, however, is the uneven distribution of physical risk across different regions. The results of the CVA indicate that the most impacted 20 per cent of Australian postcodes account for around 75 per cent of total losses in 2050, with Queensland expected to experience significantly higher losses than other states. This correlates with Climate Valuation’s own research which shows Queensland already has the highest number of high risk properties and will experience the highest increase in risk.
It’s notable that the results arising from the physical risk assessments were highly varied across the five banks. This appears to be indicative of different assumptions and methods being applied by banks. The fact that one bank found no losses in its mortgage portfolio, even under the high emissions scenario, and another “estimated minimal losses” points to a need for greater consistency in assumptions around loan duration, insurance, credit policy and government support.
In corporate lending, all but one of the participating banks “made assumptions that non-agricultural parties could materially mitigate physical risk impacts through reliance on business insurance or through operational resilience measures.” This is a highly revealing assumption. If anything, the rising cost or declining availability of insurance in high risk areas is already a factor in some of Australia’s most climate-affected regions.
The insurance bill for the last three years of unnatural disasters in Australia is over $12 billion. The floods of February and March were the most expensive natural disaster in Australia’s history. The equivalent of one in 25 Australians, including homeowners, farmers, business-owners, have lodged insurance claims.
The CVA information paper partially reveals that assumptions were built into the banks’ modelling that business insurance will cover losses and “some form of policy intervention” would support their continued lending to highly impacted regions. The experience of the last twelve months in Australia is showing that these resilience measures are not yet in place and that insurance is under strain: businesses go under when towns are hit with disaster and Government support for affected areas is limited when crises escalate. Reliance on insurance to cover escalating losses, or on the largesse of the “insurer of last resort” – public treasuries, is not risk mitigation: it is simply transferring risk to another part of the economy. Someone, eventually, will pay the bill. In other words, whilst the CVA has shown that banks might be able to manage risk in their own portfolio, it is clear that this is only possible if the risk is borne by others – either communities, directly, or by governments and taxpayers.
The CVA was limited to credit risk, and the banks’ assessments did not quantify, “a range of secondary risks from extreme climatic outcomes that could impact factors including outdoor labour productivity, public infrastructure and wider supply chain dependencies.” It also did not delve into systemic risk. This is understandable given the methods to account for these kinds of impacts are less evolved. However, banks do not need to look far to see that the IPCC has identified that 1.5 degrees of global warming puts Australia at risk that our institutions will not be able to cope, with the potential consequence that, “Climate hazards overwhelm the capacity of institutions, organisations, systems and leaders to provide necessary policies, services, resources, coordination and leadership.” (see page 1638). On a local and even regional scale, this phenomena has been evident in the Northern Rivers this year and further escalation of global warming is already locked-in.
APRA’s work in undertaking the Climate Vulnerability Assessment is to be commended. It has clearly accelerated and improved the climate risk assessment capability of the five big banks that participated. We can assume that future exercises will continue to push the sector to greater levels of sophistication in the depth and breadth of analysis. Indeed, the Financial Stability Board’s recent paper points to a number of new elements in regulatory stress tests. We now have the beginnings of a bottom-up climate vulnerability assessment for Australian banking. At the macro scale, we have a top-down picture of unbounded risk from the IPCC. The challenge in the next year is to fill out the details between the two, before the costs of climate change escalate beyond our capacity to foresee and forestall.