Yesterday (5 March), the Reserve Bank published a Bulletin article discussing the use of credit risk weights for climate-related purposes. It explains what climate-related risks are, and the Reserve Bank’s approach to them. The Reserve Bank also makes clear its ambition to enable all prudentially regulated entities to appropriately manage climate-related risks.
A link to the Reserve Bank’s media release and Bulletin can be found here and here. The Reserve Bank’s approach more generally to climate-related risks is set out in its 2021 Climate Changed Report (see here).
Who needs to read it? Why?
Compliance with the Reserve Bank’s prudential requirements will be top of mind for all registered banks, including its emerging expectations in relation to climate-related risks. The Bulletin provides context to that approach.
The Bulletin will also be of interest to borrowers and non-bank lenders when considering whether and how they may be impacted by climate-related risks (which should be included in their credit processes). The Reserve Bank’s approach to managing climate risks may also be of interest to licensed insurers, as they are also subject to the Reserve Bank’s regulation.
What does it cover?
In the Bulletin, the Reserve Bank states that “We consider enhancing climate-related risk capabilities along with the quality and availability of consistent data and priorities for banks to promote better management of climate-related risks.” These can be physical risks (e.g., natural disasters and increased Co2 in the atmosphere) or transition risks (the costs associated to transitioning to a world more significantly affected by climate change).
In part, the Bulletin is a response to submissions made by some stakeholders at the time of the Reserve Bank’s 2019 Capital Review consultation, and the further consultation on the risk weights framework to change the way that climate-related risks are incorporated, proposing using risk weights to incentivise lending to carbon-emissions reducing sectors or penalise lending to carbon-emitting sectors. The Reserve Bank also refers to the growing level of international interest in such approaches.
After setting out why climate change and the associated physical and transition risks (collectively, climate-related risks), pose risks to the stability of the financial system, and are therefore relevant to the Reserve Bank’s financial stability objective, the Bulletin is split into four main sections:
- providing an overview of the Reserve Bank’s general approach to credit risk weights;
- explaining what climate-related risks are and their links to credit risks to individual banks and financial stability at a system-wide level;
- outlining how the Reserve Bank’s credit risk weights framework currently incorporates climate-related risks within its general approach to credit risk; and
- outlining other tools that the Reserve Bank uses to help entities manage climate-related risks to financial stability, and its alignment with the recommendations of the Network for Greening the Financial System.
As part of its discussion, the Reserve Bank highlights the unique elements that distinguish climate related-risks from other kinds of risk. These include:
- the non-linear nature of many climate-related risks, social cascading effects triggered by climate change, and climate-related and economic tipping points, leading to impacts that may not be easily mitigated or reversed;
- the potential for irreversible changes in climate, leading to impacts that may not be easily mitigated or reversed;
- the far-reaching impact that climate-related risks pose to all parts of the financial system (including different business types, geographical locations and economic sectors) as well as the potential for risks to manifest across multiple lines of business at the same time, potentially disrupting financial stability;
- the uncertain and extended time horizon over which climate-related risks may materialise (which is likely to extend beyond typical business planning cycles and investment processes); and
- the unprecedented nature of climate change, meaning that traditional risk assessment methods that rely solely on historical data have the potential to systematically underestimate or even entirely fail to predict the impacts of climate-related risks. This is because of the complex dynamics of interconnected lines of business, non-linear and unprecedented levels of disruption, and compounding of risk when multiple impacts collide (or multiple climate and non-climate impacts).
The Reserve Bank then explains that there are mechanisms to incorporate climate-related risks within the approach to risk weights for credit risk for both the internal ratings-based and standardised approaches used by the four largest banks in New Zealand (referred to as the “domestic-systemically important banks"), and other registered banks respectively. These are linked to the level of financial risk to the relevant bank arising from climate change. Nevertheless, it points out that accurately including these climate-related risks is not straight-forward, and up-to-date, comprehensive data is missing in several areas.
Finally the Reserve Bank notes that it will soon publish guidance on managing climate-related risks, for all prudentially regulated entities to apply on a proportionate basis. That has been developed based on the draft guidance published in March 2023 alongside the public feedback on the associated Consultation Paper (closed in June 2023). The new guidance is intended to provide those entities with clear guidelines to develop and implement better practices in managing climate-related risks.
Our view
In what has become a somewhat crowded arena in relation to responding to climate-related risks, the Reserve Bank has a specific role to play. That is to protect and promote the stability of New Zealand’s financial system, and to avoid the significant damage to the financial system that could result from the failure of an entity the Reserve Bank prudentially supervises to adequately take account of the impact of climate-related risks.
It is good to see that the Reserve Bank recognises the focussed nature of its role with a commitment that any changes to risk weighting will be data-driven and explicitly linked to financial risk, rather than for the purposes of achieving other policy objectives unrelated to the management of financial risk. It should not go beyond that role.
It is the responsibility of Government more generally (specifically Ministries such as The Treasury, The Ministry of Business Innovation and Employment, and the Ministry for the Environment) to ensure that Aotearoa New Zealand has in place the policies and mechanisms to facilitate a transition to a low-emissions, climate resilient future, and to meet the obligations we have committed to internationally. In addition, the Climate Change Commission has the role to provide the Government of the day with independent advice on how New Zealand can address the effects of climate change, and to call out the Government if it is not doing so. Other agencies such as the External Reporting Board (XRB) and Financial Markets Authority (FMA) also have specific statutory roles, for example, under the climate-related disclosure (CRD) regime in Part 7A of the Financial Markets Conduct Act 2013 (FMCA). These are not the Reserve Bank’s responsibilities.
In line with this approach, the Reserve Bank should ensure that the guidance that it issues as prudential supervisor does not go further than is required for that purpose, and that any guidance complements the CRD regime. That requires every climate reporting entity (CRE) – which will include 17 registered banks - to publish an annual Climate Statement for each financial year starting on or after 1 January 2023. These must comply with disclosure standards (NZ CS 1 to 3) issued by the XRB, with compliance monitored and enforced by the FMA.
CS 1's objective is to require disclosure that will enable each CRE’s primary users (e.g., depositors and investors), as well as commentators and the markets, to assess the merits of how well the CRE is considering the climate-related risks and climate-related opportunities for their activities, over the short, medium and long term, and then make decisions based on these assessments.
With the planet unfortunately now on track for at least 1.5C° of change from pre-industrial times (we may be there already), there is no doubt that climate-related impacts involve financial risks. Mitigation remains important so we do not experience even higher levels of change. But adaptation to the physical and transition impacts is at least equally important. As CS 1 indicates, there will be both risks and opportunities for businesses (including banks and their customers) which factor the changes into their strategy and risk management.
What next?
As mentioned, the Reserve Bank will shortly issue its final guidance on managing climate-related risks for prudentially regulated entities. If you have any questions in relation to climate-related risk, or are considering how the Reserve Bank’s expectations may affect your business, please contact one of our experts.
In parallel, many registered banks and other large financial institutions are now in the process of preparing their first mandatory CRD under the FMCA’s CRD regime, which need to be published within 4 months of the end of the entity’s financial year. Our experience is that these entities are finding an independent legal review valuable to ensure compliance with that regime, and to identify any potential for green-washing risk arising out of the disclosure.
This article was co-authored by Elise Plunket, a Solicitor in our Banking and Financial Services team.
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