While insurers were being hit with higher costs resulting from more extreme weather, Dr Kearns said they “have a bit of a head start” because they had systems in place to assess the likelihood and costs of such events. They also had an advantage of being able to reprice premiums annually.
Banks, meanwhile, had less experience and more work to do to develop the systems and procedures to manage climate risks, as well as analyse the right data.
“Loan contracts are much longer than insurance contracts; new housing mortgages are typically for 25 years, while business loans are often for three to five years,” Dr Kearns said.
“Over these horizons, the effects of climate change are likely to be significant but are also very uncertain.
“But if climate change makes a home’s location less desirable and significantly reduces its value, the borrower may have less opportunity to refinance or upgrade their property.
“The lender may then find that the loan on that property has a much longer realised maturity, and the collateral backing the loan has a lower value.”
Dr Kearns also flagged that while banks required borrowers to insure their properties, this was becoming more difficult to obtain or retain due to the effects of climate change “either because insurers won’t cover it, or the cost of insurance has increased significantly”.
“If climate change means a home isn’t insured, then lenders could find that damage from flood, storm or fire results in the collateral value being significantly lower, and so their expected loss-given default on climate-impacted properties is much larger,” he said.
“Because of the substantial uncertainty they face, banks use scenario analysis to consider how their exposure to climate change depends on various parameters and behaviours.”
The Australian Prudential Regulation Authority has begun work with the five largest banks – Commonwealth Bank, Westpac, National Australia Bank, Macquarie Group and ANZ Banking Group – to evaluate their vulnerability to climate change.
“Individual bank results were provided to APRA in late May 2022, and APRA is looking to publish information on the outcomes and insights later this year after analysing these submissions,” Dr Kearns said.
“It is not only the banks that will learn from the CVA (climate vulnerability assessment), but regulators will also learn how to better assess climate risk in the Australian financial system.”
The banks have also all joined the Net Zero Banking Alliance, which was formed on the sidelines of COP 26 in Glasgow, pledging to achieve net zero emissions through their financing by 2050.
Under the NZBA, they are required to tackle the most emissions-intensive industries first, with Westpac and NAB announcing plans to stop funding high-intensity sectors such as gas and tackle agricultural and manufacturing emissions in a second step.
The big four banks’ mortgage books, while having low emissions intensity, comprise a large component of their overall emissions, ranking behind manufacturing and agriculture depending on the bank.
Greening the electricity grid is considered the best way to fix mortgage book emissions, but the ramifications of rising insurance costs and availability in flood and fire-prone regions have become more pronounced.
Climate disclosures
Dr Kearns also pointed to work by the Council of Financial Regulators to align Australia’s climate disclosures with those globally by participating in the International Sustainability Standards Board’s consultation processes.
While the ISSB would make common reporting language for investors globally, he said the Australian Sustainable Finance Institute’s new taxonomy should carve out definitions of “green” or “sustainable” based on the individual country’s starting position.
“While we want consistency, the definitions need to be appropriate for the structure of an economy, noting countries have different starting points for the transition to net zero,” he said.
Given Australia’s relatively high carbon intensity as a predominantly coal-fired economy, he said the path to net zero may involve investments that reduced total carbon emissions, but were not purely green.
“There is also a risk that jurisdictions without a taxonomy will see international investors apply definitions they are familiar with, such as the proposed European Union taxonomy, whether they are suitable to that economy or not,” Dr Kearns said.
“For example, the EU taxonomy may label LNG as not being a green investment unless it meets stringent requirements that are not applied in Australia. However, in the near term, increased use of LNG in Australia may assist a transition away from coal while renewables infrastructure is developed.”
