Reserve Bank Governor Adrian Orr says mandatory climate-risk disclosure standards under development will help fill a void by providing more detail on identifying, pricing and allocating risk from climate change within the financial system.
In a speech on Monday on why climate matters to the Reserve Bank, Orr describes the financial system as a critical engine working to identify, price, and allocate risk.
"Climate risks are evolving, and the market is working to come up to speed on those risks. But historically, that engine hasn’t fully addressed potential risks from climate change," says Orr.
"This is partly because we simply do not know the true scope and scale of the environmental risks we take on during our daily economic activities. Transition risks have also proved elusive: it’s hard to identify a risk when the timing and magnitude of climate policies in New Zealand or overseas are unknown."
"Likewise, many of the material costs of our economic decisions are ‘externalised’, that is, borne by others including future generations. Solving the moral hazard of transition costs falling on the present generation, while the benefits of those actions, in reduced climate impacts, accrue to future generations, has proved a tall order," Orr says.
"What this means is that we will never have perfect information on the risks of climate change. However, the mandatory climate-risk disclosure standards being developed by the External Reporting Board (XRB) and regulated by the Financial Markets Authority (FMA), will help start closing some of those information gaps."
"Firms’ disclosure on how they identify and manage climate change risks will help to bring those risks into focus for management and investors alike. After all, it is what gets measured that generally gets managed. And it is far often better to imperfectly measure something than ignore it completely, in particular when it helps guide investor decisions. In measuring climate risk, climate disclosure can shed light not only on those risks, but also transition opportunities," says Orr.
Without adequate disclosure to help identify and price risks, Orr says change may be disorderly and much more difficult to manage.
"Historically, the financial system has not fully accounted for the consequences of climate change. But New Zealand’s financial history is still being written – and disclosure has the potential to be a key part of that story," he says.
The XRB is an independent Crown entity tasked with preparing and issuing accounting standards and audit assurance standards. Climate-related disclosures will be mandatory, from next year, for listed companies with a market capitalisation of more than $60 million, large licensed insurers, registered banks, credit unions, building societies and managers of investment schemes with more than $1 billion in assets, plus at least some Crown financial institutions via a letter of expectation from their relevant Minister.
The XRB's final consultation on the climate-related disclosure standards, which it says about 200 of New Zealand’s largest entities will need to report against from next year, is currently open. XRB CEO April Mackenzie says the disclosure standards are ultimately about driving investment and capital away from high-emissions activities and towards low-emissions activities.
"We are confident the disclosure regime we’ve developed will support that transition," Mackenzie says.
XRB plans to issue the standards in December, and for them to be effective from 1 January 2023, meaning they'll be effective for all climate reporting entity's next reporting periods.
Meanwhile in Monday's speech, Orr also noted the introduction of a climate change risk element into the Reserve Bank's annual solvency stress test of banks last year, by including a two-year North Island drought in the scenario.
"Our modelling showed that the drought, on its own, did not create undue stress. However, when combined with an economic downturn the drought caused a 40% increase in dairy loan defaults over four years, before returning to level similar to today. This result illustrates the importance of nonlinearities in financial impacts from climate change," Orr says.
This year's bank stress tests will assess the impact of rising interest rates and climate change on banks.
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