Mirroring other leading financial sector regulators across the globe, South Africa’s Prudential Authority (PA) has signaled to banks and insurers that it is time for them to consider and integrate climate-related risks into their business practices, strategy, and management and disclose climate-related risks.
The PA has released four proposed guidance notes for comment by banks (as well as branches of foreign institutions, controlling companies, eligible institutions, and auditors of banks or controlling companies) and insurers on climate-related disclosures and risk practices. This guidance contains critical recommendations on governance, strategy, risk management, metrics and targets relating to climate-related risk.
The guidance notes must be understood in the context of growing regulatory initiatives globally to integrate Environmental, Social and Governance (ESG) and sustainable finance into mainstream financial systems. Historically, climate related and other ESG risks were not adequately factored into capital allocation decisions or pricing. This has resulted in a financial system that fails to appreciate and cost environmental and social externalities. Sustainable finance efforts by various financial market participants on a voluntary basis, and now by regulators, aim to integrate these externalities, which are viewed as critical to resilience and financial stability.
The guidance notes demonstrate the changing perceptions of climate-related risks. These risks are viewed as having an impact on banking institutions, regardless of their size, complexity, or business model. Importantly, banks and insurers are expected to treat climate risk as a financial risk rather than merely a reputational risk event. This has implications for the way that climate-related risks are integrated into risk management frameworks and business models.
According to the PA, the insurance industry plays a critical role in the management of climate-related risks in its capacity as an assessor, manager, and carrier of risk, and as an investor and steward of financial resources. It is also uniquely qualified to understand the pricing of insurance risks. Climate-related risks have the potential to impact the solvency position of an insurer, as well as its ability to raise capital, and they could affect the valuation of assets and liabilities in both life and non-life insurers from the perspective of both physical and transition risks.
The PA says an essential function of financial markets is to price risk to support informed, efficient capital-allocation decisions. Disclosures can enhance how climate-related risks are assessed, priced, and managed nationally and internationally. The guidance notes adopt the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and the International Sustainability Standards Board (ISSB). The ISSB recently published inaugural standards that aim to promote consistency and comparability in sustainability reporting and disclosure. Climate-related disclosure should be produced simultaneously with banks’ and insurers’ annual reports, or more frequently if material information is available.
The guidance notes set out the key role players and their respective responsibilities to manage and integrate climate-related risks and disclosures. Boards of directors and senior management should ensure appropriate allocation of oversight and management responsibilities for managing climate-related risks. Certain management aspects may be delegated, but the board has the responsibility to monitor the exercise of the delegated functions. The board and senior management should develop comprehensive policies and processes that will assist in identifying climate-related risk drivers and assessing the potential impacts thereof. The board should disclose its practices and processes in maintaining oversight over climate-related risks and their impact on the financial institution, as well as the role of senior management in assessing and managing climate-related risks and opportunities. The board should remain cognisant of potential direct legal action against the institution for failing to manage climate-related risks.
Also noteworthy is the role envisaged for the compliance function of banks and insurers in ensuring that climate-related risks are identified and accounted for in compliance risk management frameworks. The PA says from the perspective of the compliance function, climate-related risks relate to legal risk (liability risk), i.e. the risk of climate-related claims as well as direct actions against institutions for failing to manage climate risks, and legal change risk (disclosure risk related to the failure to disclose climate-related risk exposures).
There are many other important aspects in the guidance notes, including:
- the need for appropriate resourcing and capacity to grasp the specialist nature of climate-related risk from the Control Functions;
- the multiple references to appropriate international frameworks;
- the need for metrics and targets that are sufficiently detailed to manage climate-related risks and opportunities, and disclosure of performance against these targets;
- reference to the South African green finance taxonomy;
- the need to undertake transition planning and compile transition plans in proportion to their size, business model and complexity; and
- currently the disclosures are not expected to be subject to independent external assurance but in future external assurance is expected.
The draft guidance notes focus on climate-related risks. However, climate change and the just transition to a low carbon economy also bring opportunities. The PA’s stated approach to climate-related risks is one of proactivity. It specifically encourages financial institutions not to wait for regulation or to be compliance driven. Developments and improvements in approach are not considered sufficient justifications for delaying implementation when it comes to climate risk management. Climate-related disclosures are expected to become mandatory over time.
The publication of the final versions of the guidance notes is inevitable and imminent. It is therefore critical that financial institutions grasp the significance of these guidance notes and the implications for their businesses. Our multi-disciplinary ESG team advises clients in the financial sector on the integration of ESG and sustainable finance initiatives, including climate-related risks. The deadline for comments on the Proposed Guidance Notes is 13 September 2023.