RBNZ seeks feedback on managing climate risks in the financial sector

By Dan Brunskill

The Reserve Bank of New Zealand (RBNZ) is seeking feedback on new guidance on how the financial sector should manage climate-related risks, such as flooding and sea level rise.

A draft guidance document sets out how the central bank and regulator expects banks, insurance companies, and market infrastructure operators to assess and manage climate risks.

RBNZ Deputy Governor Christian Hawkesby said the recent flooding and cyclone highlighted how climate change was already impacting the country.

“Climate-related risks continue to evolve, with the potential to significantly affect the financial system in the future,” he said in a statement.

Earlier this week the central bank released a report which showed a quarter of residential mortgage lending was exposed to a flood zone, and 2.5% of mortgages would be affected by sea level rise of 50 centimeters.

It is this type of risk regulators around the world are wanting financial institutions to consider and prepare for with the new guidance.

The RBNZ report found banks had enough capital to cope with the scenarios it modeled, but not if they coincided with other shocks — such as a severe economic downturn.

A consultation paper released on Wednesday invites public feedback on the draft guidance which asks financial entities to model possible impacts of more frequent floods, droughts, and extreme weather.

The RBNZ said climate-related risks included not only the physical risk but also transition risks, such as what would happen if insurers stopped covering mortgaged homes in flood zones.

The central bank’s work on climate change risks has been criticised for being too prescriptive, when financial institutions are always considering and looking to minimise their own losses.

If climate change poses a financial risk then institutions will naturally adjust and price in those risks, critics have said.

The RBNZ doesn’t disagree and the draft guidance encourages entities to manage climate-related risks within a broader risk management framework.

However, it argued that climate risks deserve special attention due to the “non-linear nature” of global warming. The planet’s temperature has been increasing gradually but is expected to hit a “tipping point” where its impacts may not be easily mitigated or reversed.

Unprecedented, far-reaching

The far-reaching impact of climate risks also poses a threat to all parts of the financial system and could hit all business sectors and geographical locations at once — this could disrupt financial stability.

Finally, the central bank said that because climate change was unprecedented, traditional risk assessments that rely on historical data could systematically underestimate its impacts.

Climate risks could have a compounding effect on more regular business risks such as loan defaults, the re-pricing of financial assets which affects balance sheet strength, liquidity risks in an extreme event, and even legal risk from climate-related litigation.

The draft guidance encourages financial entities to identify lending sectors with higher exposures to physical and transition risks.

“It is important to understand counterparties' vulnerabilities to these kinds of threats for identifying and quantifying the risk borne by the entity, not just at the sectoral level but also at the individual counterparty/collateral level,” it said.

The risk criteria it suggests includes factors such as the level of vulnerability to extreme weather events, and whether those events can be insured against, the level of greenhouse gasses and exposure to changes in emission pricing.

It also recommends looking at counterparties' exposure to possible changes in climate policy, and links to “unsustainable practices”.

Banks and other financial institutions already consider many of these things, but doing so has not been uncontroversial and has led to some sectors struggling to access funding overseas.

While the guidance doesn’t explicitly call for banks and insurers not to provide services to counterparties that are exposed to climate risk, it could be interpreted as doing so.

“Where it has identified material climate-related risks, we consider it prudent for an entity to establish and implement plans to mitigate these risks and manage exposures in line with the governance body - approved risk appetite”.

It suggests entities might “develop strategies to manage concentrations in its portfolio to specific geographic or economic sectors with higher climate-related risks” which could include setting exposure limits to that sector.

The draft guidance is now open for feedback and the Reserve Bank hopes to publish a finalised version in the second half of this year.

This story was originally published on Interest.co.nz and has been republished here with permission.