Mon, Dec 11, 2023

The official Financial Regulation Journal of SAIFM

Prudential Authority Publishes Proposed Guidance Notices on Climate-Related Risk Practices and Disclosures for Financial Institutions

Nicole Britton, Ernie Van Der Vyver and Kate Swart

On 3 August 2023, the Prudential Authority published four proposed guidance notices on climate-related risk practices and disclosures for banks and insurers:

a proposed guidance notice on climate-related risk practices for insurers (Insurers Risk Practices Guidance Notice);

a proposed guidance notice on disclosures for insurers (Insurers Disclosures Guidance Notice);

a proposed guidance notice on climate-related risk practices for banks (Banks Risk Practices Guidance Notice); and

a proposed guidance notice on climate-related disclosures for banks (Banks Disclosures Guidance Notice).

The proposed guidance notices constitute the anticipated regulatory guidance setting out the Prudential Authority‘s expectations on how climate risks should be integrated into supervised institutions’ risk management, governance and reporting processes, in line with Prudential Communication 10 of 2022 on Climate-related risks.

Insurers Risk Practices Guidance Notice

The Insurers Risk Practices Guidance Notice aims to assist insurers in complying with the requirements of the Governance and Operational Standards for Insurers (GOI) in relation to two Prudential Standards – the Risk Management and Internal Controls for Insurers Prudential Standard (GOI3) and Own Risk Solvency Assessment (ORSA) for Insurers Prudential Standard (GOI 3.1).

It is proposed that climate-related risks must be addressed through three key areas – governance, risk management and ORSA.

Governance: the board of directors retains ultimate responsibility for the effective governance of climate-related risks, and various roles and responsibilities of the board of directors and senior management are identified, together with a proposal for policies and strategies to be adopted.

Risk Management: an integrated and holistic approach must be adopted, with insurers incorporating climate-related risks into existing risk and corporate governance frameworks, and focussing on the impact of climate-related risks on assets, liabilities and the insurer’s business model, as well as its solvency. The approach to be taken by the risk management function, compliance function, actuarial function, internal audit function and control function competencies are also outlined. The potential impact of climate-related risks on outsourced service providers must also be considered, and transitional plans should be put in place.

ORSA: The climate-related risk exposure of an insurer impacts the nature and materiality of the relevant insurance, credit, market, concentration, operational and liquidity risks to varying degrees. By utilising the ORSA, insurers can assess the adequacy of its enterprise risk management and capital position in relation to climate-related risks. The ORSA must include scenario analysis and stress testing as part of the assessment process, incorporating an assessment of physical, transitional and liability risks. Specific reporting requirements in respect of the ORSA are set out where climate-related risks are assessed to be material by an insurer.

Insurers Disclosures Guidance Notice

The Insurers Disclosures Guidance Notice aims to provide guidance to insurers on climate-related disclosures, taking into consideration the recommendations of the Taskforce for Climate-related Financial Disclosures (TCFD) and the International Sustainability Standards Board (ISSB), under the four thematic areas of governance, strategy, risk management and metrics and targets. It emphasises the necessity of disclosures of climate-related risks and opportunities to promote market discipline within the financial markets industry through the provision of meaningful information to stakeholders on a consistent and comparable basis.

In this regard, insurers are required to produce climate-related disclosure reports, and principles governing the manner in which such reporting is carried out are set out by the Prudential Authority in the Insurers Disclosures Guidance Notice. A few disclosures that should be made in these disclosure reports, include:

the practices and processes in maintaining oversight over climate-related risks and their impact on the financial institution;

the current and anticipated impacts of climate-related risks and opportunities on the institution’s business, strategy, and financial planning where such information is material;

risk management policies and processes for identifying and assessing climate-related risks and managing these (including policies and transition plans), and how these are integrated into the institution’s overall risk management; and

the metrics and targets that enable stakeholders to evaluate the institution’s exposure, measurement and management of climate-related risks, clearly stating the ambition level and quantitative and qualitative aspects.

Although the disclosures are not expected to be subject to independent external assurance currently, it is recorded that such disclosures should work towards a future state in which external assurance is expected, and should be subject to internal governance processes.

Banks Risk Practices Guidance Notice

The Banks Risk Practices Guidance Note is intended to be issued in terms of section 6(5) of the Banks Act 94 of 1990 (Banks Act), which empowers the Prudential Authority to issue guidance notes to banks, controlling companies, representative offices, eligible institutions and auditors of banks or controlling companies with information in respect of market practices or market or industry developments within or outside of South Africa. The proposed Banks Risk Practices Guidance Note contains guidance to banks, branches of foreign institutions and controlling companies (collectively ‘banks’) on integrating climate-related risks into their governance and risk management frameworks, including guidance on banks’ internal capital adequacy assessment process (ICAAPs).

In light of the fact that climate change may result in physical and transitional risks that could affect the safety and soundness of individual banks and have broader financial stability implications for the banking system, the Prudential Authority intends to publish this guidance notice to contribute to the strengthening of the regulation and supervision of climate-related risk management within banks for the purpose of enhancing financial soundness and stability.

It is proposed that climate-related risks must be addressed through three key areas – governance, risk management and ICAAP.

Governance: The board of directors and senior management of banking institutions should develop processes and policies for assessing potential impacts of climate-related risks on their business model, overall strategy and environment in which they conduct business, as well as assigning clear roles and responsibilities to manage and oversee climate-related risks within the institution. Banks are tasked to adopt robust governance policies to identify, monitor, report and mitigate climate related risks impacting the bank, as well as managing climate-related risks within their overall business strategy and risk appetite.

Risk Management: banks should integrate climate-related risks into their risk management frameworks, managing such climate-related risks proportionately to the size and complexity of the institution, and demonstrating that climate-related risks have been considered as part of strategic planning and business practices. Exposure to climate-related risks should be identified, measured, monitored and reported on by banks. The approach to be taken by the risk management function, compliance function, actuarial function, internal audit function and control function competencies are also outlined. The potential impact of climate-related risks on outsourced service providers must also be considered, and transitional plans should be put in place.

ICAAP: climate-related risks may have an impact on banking institutions of any size, complexity or business model, and the regulatory capital framework therefore places increased emphasis on risk management. Banks are required to employ suitable process, procedures and systems to ensure capital adequacy commensurate with their risk profile in order to safeguard against these risks. It is therefore imperative for banks’ ICAAP to ensure adequate coverage to exposures. Banks are expected to use scenario analysis to understand the impact of climate risk on their solvency and liquidity, and they should have written policies in place governing scenario analysis and stress testing methodologies. The manner in which banks should carry out such stress testing is set out, as well as the reporting content which ICAAP should follow.

Banks Disclosures Guidance Notice

The proposed Banks Disclosure Guidance Notice is likewise issued in terms of section 6(5) of the Banks Act, and has the same purpose as the Insurers Disclosures Guidance Notice. The two disclosure guidance notices are almost identical in content, with the Bank Disclosure Guidance Notice providing guidance to banks on climate-related disclosures, taking into consideration the recommendations of the TCFD and the ISSB under the four thematic areas of governance, strategy, risk management and metrics and targets.

Insurers, banks and other interest persons are invited to submit their comments on all four of the proposed guidance notices to the Prudential Authority by no later than 13 September 2023.

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