The impact of climate change on New Zealand's financial system
Climate change will have a significant effect on New Zealand’s economy and financial system. The Reserve Bank has a strong interest in climate change, as understanding, quantifying and managing risk is critical to many of its core functions, including promoting a sound and efficient financial system.
Climate change has physical and transitional impacts…
New Zealand’s financial system is primarily exposed to climate risks through the sectors that it lends to and insures. The financial system will be affected by both the physical and transitional impacts of climate change. The physical impacts of climate change will pose risks through damage to property, changing property values, and disruptions to supply chains. The transitional impacts, which reflect the shift of New Zealand and other countries to lower-carbon economies, may pose risks through the impact of regulatory changes, technological advances and changes in consumer and investor preferences. There is also potential for significant liability risks to emerge.
…including on the agriculture and property sectors.
Managing exposures to assets linked to primary industries will be a major global challenge. For many countries, emissions from fossil fuels and the energy sector will be the key areas of focus. But for New Zealand, it will likely be the agriculture sector, which accounts for around half of our emissions.
The physical risks for the agriculture sector are not expected to be material in aggregate. However, regional impacts will vary, and increased volatility in weather patterns may impact farm costs and production. It is important that banks’ lending decisions account for farm-specific exposures to these climate risks.
Transition risk is likely to be more significant for the agriculture sector. The treatment of the sector in policies to reduce emissions remains unclear, but it seems inevitable that some of the burden will fall on it. It is in the interests of farms and lenders that this uncertainty be removed and that any new rules are implemented through clear and prudent transitional arrangements. Risks to the financial system are likely to increase if changes are implemented too quickly or delayed to the point that sudden, more material, changes are required to meet New Zealand’s international commitments.
The financial system is also exposed to the effects of climate change on property. Coastal property is likely to be the most affected, as rising sea levels may result in some properties being lost to the sea entirely. However, more frequent extreme weather events could see broader impacts on properties across the country.
Insurers and banks need to reflect climate risks in their decisions…
Property insurance penetration is high in New Zealand, so these risks may crystallise in the insurance sector. However, most property insurance contracts are negotiated annually, allowing insurers to re-assess risk and adjust policy terms each year. Some insurers in New Zealand appear to have begun adjusting their products and pricing to reflect emerging climate risks, and some existing properties could ultimately become uninsurable. Whilst this supports the efficiency and stability of the insurance sector, it poses challenges for property owners and lenders.
An increase in the cost of insurance or a reduction in its availability may reduce the value of affected assets. In the first instance, this represents a cost to the owners of the assets. But these costs will also translate into higher risks for lenders if the value of loan collateral falls or underinsured borrowers suffer losses.
More generally, lenders protect against the risk of losses on loans by assessing the value of property security, assessing the capacity of borrowers to service their loans, and requiring ongoing insurance coverage in loan contracts. To work effectively it is essential that these processes are calibrated to longer-term risks, including climate change. This may mean placing less reliance on backward-looking valuation models, strengthening serviceability tests to incorporate the potential future variations in insurance costs, and investing in systems to monitor ongoing insurance coverage and exposure to physical risks.
The Reserve Bank will engage further with banks and insurers to understand how they are incorporating these and other climate-related risks within their businesses.
…but a broader response will be required.
No single institution working alone can achieve any meaningful progress on a global issue like climate change. Within New Zealand, action will be required from a range of parties to ensure that the financial system remains sound and efficient in the long term:
- Financial sector participants have a critical role in assessing their own current and future exposures, ensuring the appropriate allocation of financial resources through robust lending standards and insurance underwriting policies, and providing the necessary finance for mitigation actions.
- The Reserve Bank has an important role in monitoring climate risks across the system and incorporating them within regulatory frameworks, driving appropriate disclosure to help market participants assess climate-related exposures, and addressing any barriers to the development of green finance.
- Government has a vital role in driving the transition to a low-carbon economy and in alleviating uncertainty by developing robust and durable frameworks that can be analysed and priced by market participants.
Whilst it is not possible to predict future climatic developments with certainty, it is essential that all sectors of the economy work within a coherent national strategy on climate change. Decisions about future investment and development should factor in long-term climate risks. Decision-makers should take responsibility for the risks that they are building today, such as by avoiding building infrastructure in vulnerable locations where not essential.
The Reserve Bank is developing its own climate change strategy.
The strategy focuses on ensuring that climate risks are appropriately incorporated within the Reserve Bank’s mandate. The Reserve Bank also stands ready to collaborate with industry and government to help position New Zealand for the challenges ahead.