Thursday, 10 October 2019

Australia's Reserve Bank addresses financial risks from climate change - a topic which the Morrison Government continues to ignore

The Northern Rivers region of New South Wales has three very valuable natural assets - a coastline with numerous beaches, many unregulated rivers and a predominately rural landscape which is interspersed with large forested tracts of land.

This month the Reserve Bank of Australia reminded us that the financial contribution these assets make to our regional economy are at increasing risk from the impacts of climate change.  

Reserve Bank of Australia, Financial Stability Review – October 2019,
Box C Financial Stability Risks From Climate Change:

Climate change is exposing financial institutions and the financial system more broadly to risks that will rise over time, if not addressed. According to the Intergovernmental Panel on Climate Change (IPCC), it will take significant effort to limit global warming to 1.5°C above pre-industrial levels, as targeted in the Paris Agreement. Even if targets are met, this level of warming is likely to be accompanied by rising sea levels and an increase in the frequency and intensity of extreme weather (including storms, heatwaves and droughts). Some of these outcomes are already apparent (Graph C.1). These changes will create both financial and macroeconomic risks.[1]
This box focusses on the financial risks arising from climate change, particularly for Australian financial institutions. These risks can be classified as either:

* physical: disruptions to economic activity or reductions in asset values resulting from the physical impacts of climate change; 

* transitional: the impact of changes in regulation or pricing introduced to facilitate a transition to a low-carbon economy; or 

*liability: an inadequate response to these risks also raises the potential for reputational and legal risk. 

While climate change is not yet a significant threat to financial stability in Australia, it is becoming increasingly important for investors and institutions to take account of and manage these risks. 

Climate change poses some material risks to Australian financial institutions 

The physical effects of climate change can have a significant impact on Australian financial institutions. As an example, inflation-adjusted insurance claims for natural disasters in the current decade have been more than double those in the previous decade. This impact is likely to grow over time. 

An increase in the frequency and severity of natural disasters will increase the incidence of damage to, or destruction of, physical assets that are insured or used as collateral. Assets that are exposed to increasing physical risk (such as property located in bushfire-prone or coastal areas) could decline in value, particularly if these risks become uninsurable. Climate change could also reduce certain types of business income that is used to service loans. Examples include changing rainfall patterns that result in lower or less predictable income from agriculture, more frequent storms disrupting supply chains and therefore sales, and damage to natural assets that reduces tourism income. 

Insurers are most directly exposed to the physical impacts of climate change. This can arise through natural disaster claims, crop insurance, and health and life insurance. While insurers can increase their premiums to reflect higher risk, it is difficult to accurately price new and uncertain climate risks. If insurers under-price these risks, it could threaten their viability in the event of extreme weather events resulting in very large losses. On the other hand, over-pricing would impede the risk pooling function provided by insurance and unduly limit economic activity. Even if correctly priced, more of these risks may become uninsurable, forcing households, businesses or governments to bear this risk. 

Banks (and other lenders) are also exposed to physical risks because climate change can result in a decline in the income or value of collateral that they are lending against. Such effects can go beyond the industries directly affected by climate change (such as agriculture and tourism), to the households and businesses that rely on income from those industries. 

Australian financial institutions that have exposure to carbon-intensive industries – such as power generation and mining, or to energy-intensive firms – will also be exposed to transition risk. 

Transition to a lower carbon economy can also affect institutions with exposures to individuals and communities reliant on these industries. Sudden or unexpected regulatory change could quickly lower the value of such assets or businesses, some of which may become economically unviable or ‘stranded’. Such regulatory changes could either be domestic or come from abroad, given the carbon intensity of Australia's exports. Transition risk could also arise if large investment in technologies allowed new entrants to displace established but emissions-intensive practices, or if consumer preferences shifted rapidly towards ‘green’ products. If such changes occur abruptly, and certain sectors or firms face large losses, there could be broader dislocation in financial markets, despite the opportunities created for some firms from these changes. Transition risk will be greatest for banks that lend to firms in carbon-intensive industries and to individuals or businesses that are reliant on these firms. Other financial institutions investing in carbon-intensive industries, such as superannuation and investment funds, are also exposed to the risk that climate change will diminish the value of their investments. This could occur both through direct investments in carbon-intensive industries, or indirect investments in banks that lend to these industries. 

Financial institutions may also face reputational damage if they are seen to be contributing to climate change or failing to manage climate risks. This could affect an institution's ability to retain customers and raise funding. Firms also face legal risks if directors fail to address the potential exposure of their firms to climate-related risks, according to the Hutley opinion (a landmark legal opinion on directors' duties in relation to climate change under Australian law).[2]

Climate risks are challenging to manage and there are significant data gaps.

Australian financial institutions have become increasingly aware of the financial nature of climate risks and are taking steps to assess and manage their exposure to physical and transition risks. But it is difficult to map the impacts of climate change to changes in asset values and financial losses. The risks from climate change are particularly difficult to assess because of their long-term nature and complexity. These risks involve a great deal of uncertainty due to unknown future policy responses and the possibility that feedback loops and tipping points may lead to greater and/or more rapid physical impacts than is currently expected. Climate risks also have the potential to be correlated across regions, requiring institutions to reassess the benefits from geographical diversification.

Read the remainder of this section here.

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