RBA says it is becoming increasingly important for investors and institutions to actively manage carbon risk

Australia’s central bank has delivered a clear warning that climate change is exposing financial institutions and the financial system more broadly to risks that will rise over time if action isn’t taken.

The RBA’s financial stability review, released Friday, concluded that while climate change is not yet a significant threat to financial stability in Australia, it is becoming increasingly important for investors and institutions to actively manage carbon risk.

The bank notes Australian insurers are the most directly exposed to the physical impacts of climate change, and points out that inflation-adjusted insurance claims for natural disasters this decade are more than twice what they were in the previous 10 years. It notes “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,” the RBA said.

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“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.”

The RBA says banks and other lending institutions 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.

It says 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 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,” the bank said.

“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”.

It warns financial institutions “also face reputational damage if they are seen to be contributing to climate change or failing to manage climate risks”.

The RBA concludes that climate change poses a clear systemic risk, but it is not yet an imminent threat to financial stability. But it warns this could change. “Climate change could emerge as a risk to financial stability if it is not properly managed, or if the size of climate-related losses increased materially.

“Rising climate-related losses could also erode confidence in an institution or the financial system, leading to a withdrawal of funding. This would be more likely if the physical impacts of climate change are more severe or occur sooner than currently projected, or if the transition to a low-carbon economy occurs in a disruptive and costly manner.”

The RBA notes that both the banking regulator Apra and the corporate watchdog Asic have become proactive in managing carbon risk, and the Council of Financial Regulators has established a working group on the financial implications of climate change to help coordinate agencies’ actions.

Friday’s analysis builds on a warning by the Reserve Bank deputy governor, Guy Debelle, who said in March climate change posed risks to Australia’s financial stability.

Debelle said policymakers needed to consider warming as a trend and not a cyclical event. He said policymakers and businesses needed to “think in terms of trend rather than cycles in the weather”.

“Droughts have generally been regarded, at least economically, as cyclical events that recur every so often. In contrast, climate change is a trend change. The impact of a trend is ongoing, whereas a cycle is temporary.”

The deputy governor said there was a need to reassess the frequency of climate change events, and “our assumptions about the severity and longevity of the climatic events”.

In March, Apra flagged an intention to increase scrutiny of how banks, insurers and superannuation trustees are managing the financial risks of climate change to their businesses.

Last year Asic said climate change was “a foreseeable risk facing many listed companies in the Australian market in a range of different industries” and warned directors and management of listed companies “to understand and continually reassess existing and emerging risks including climate risk that may affect the company’s business”.

In that same assessment by the corporate watchdog, 17% of listed companies in the Asic sample identified climate risk as a material risk in their operating and financial reviews.

The RBA noted on Friday, according to the Intergovernmental Panel on Climate Change (IPCC), it will take significant effort to limit global warming to 1.5C 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,” it said. “Some of these outcomes are already apparent. These changes will create both financial and macroeconomic risks”.