APRA escalates ESG requirements for super trustees

02 August 2022

Key points

APRA’s 19 July announcement of proposed environmental, social and governance (ESG) risk management guidance for registrable superannuation entity (RSE) licensees is a firm indication that the prudential regulator will be setting clear expectations on how RSE licensees should manage ESG risks as they relate to their investments.
For the first time, APRA is foreshadowing that it will explicitly expect RSE licensees to specifically take into account the full spectrum of ESG risks, including mandating scenario testing for climate change risk, and covering human rights violations in supply chains, corruption and other risks.
RSE licensees should take steps now to adapt their investment practices and compliance frameworks in time for 1 January 2023, when the new guidance is anticipated to take effect. Fund managers can expect trustees will look to quickly pass on mirroring compliance measures in their mandates.
Corrs is developing submissions as part of the proposed consultation process.

Background

Submissions to APRA call for enhanced guidance on the consideration of ESG financial risks

During public consultation about Prudential Standard SPS 530 Investment Governance (SPS 530), a number of submissions called for enhanced guidance on the consideration of ESG financial risks (including specific reference to ESG risk as a material risk to be considered at both the idiosyncratic and market-wide level).

Some submissions called for greater clarity on the interplay between Prudential Practice Guide CPG 229 Climate Change Financial Risks (CPG 229) and Prudential Practice Guide SPG 530 Investment Governance (SPG 530); others noted that SPG 530 currently limits the consideration of ESG factors to the offering of ethical investment options.

APRA responds to ESG risk submissions

On 19 July 2022, APRA announced its intention to release for consultation new draft guidance RSE licensees to manage ESG-related investment risks.

APRA’s announcement came when it released — after a public consultation process — the final revised version of SPS 530, due to commence on 1 January 2023. SPS 530 aims to ensure that RSE licensees, consistent with their obligation to act in the best financial interests of beneficiaries, prudently select, manage and monitor investments on behalf of beneficiaries. While the prudential regulator has finalised its updates to SPS 530 (which are relatively minor), it is yet to release its proposed updates to relevant guidance for SPS 530 (namely, SPG 530).

APRA guidance to be released

In response to the submissions above, in its announcement APRA said:

Further APRA guidance is called for: SPS 530 already requires RSE licensees to manage and monitor all sources of investment risk (including ESG investment risks). However, APRA recognises the increasing significance and materiality of ESG financial risk factors.
Guidance may include stress testing: APRA’s guidance to RSE licensees may refer to demonstrating, through scenario analysis and stress testing, the impact of investment decisions and risk management on the investment portfolio and the broader market.
SPG 530 and CPG 229 clarification: APRA intends to clarify the linkages between SPG 530 and CPG in the upcoming release of draft SPG 530, particularly with reference to stress testing, and that ESG financial risk considerations are expected to cover matters beyond climate change financial risk. CPG 229 recognises that climate risks are an evolving area for RSE licensees to assess and manage, and sets expectations for the management of climate risks.

Important implications for RSE licensees

APRA’s announcement, although a clear statement of its general intent, leaves open what specific expectations will be set in relation to the management of ESG risks.

However, it is clear that management of such risks through a robust compliance framework is expected. The announcement foreshadows several significant potential developments in prudential regulation, including:

APRA’s expectations are changing: Although practical guidance such as SPG 530 does not create enforceable legal requirements, they reflect APRA’s regulatory expectations. As such, failure to adhere to APRA’s view of sound investment practice raises the risk of regulatory action.
Guidance to cover the full spectrum of ESG risks: APRA now explicitly expects RSE licensees to specifically take into account the full spectrum of ESG risks in fulfilling their obligations under SPS 530 to formulate an appropriate investment strategy and manage investment risks.
ESG risk spectrum will be very broad: Such risks are diverse (encompassing climate change, human rights violations in supply chains and corruption, to name a few examples), and may impact the financial performance of investments in a wide variety of ways (e.g. deterring ethically conscious investors and customers, reputational harm, litigation and regulatory enforcement action and so on). As such, RSE licensees may need to make significant updates to their investment strategy and practices in order to meet APRA’s expectations.
Link between SPG 530 and CPG 229 to be clarified: Of particular significance is APRA’s intention to strengthen the link between SPG 530 and CPG 229 (particularly with reference to stress testing for a broad range of ESG risks). In brief terms, CPG 229 articulates an expectation that RSE licensees use stress testing for climate risks, by identifying the material climate risks to which they are exposed, simulating scenarios in which those risks arise and then analysing performance for potential improvements. APRA’s statement suggests that SPG 530 may be updated to contain similar stress testing expectations in relation to all ESG risks, not just climate risks.

RSE licensees should start to act now to consider emerging ESG risks

There are a number of practical steps that RSE licensees should consider taking in response to the announcement.

We recommend RSE licensees consider:

Investment governance updates: Preparing to update investment governance frameworks (as required by SPS 530) to introduce systems for identifying the full suite of ESG-related risks associated with their investments, and monitoring and managing those risks.

Boards and management should be able to demonstrate an understanding of how ESG risks impact strategy and risk appetite and oversee development and delegation of ESG related accountabilities. This involves setting up appropriate committees and risk reporting functions.

Management should also be responsible for regular reporting to the Board and committees on the level and nature of ESG risks. Reporting should address both qualitative and quantitative risk measures.
Framework, policy and procedure updates: Identifying which frameworks, policies and procedures for the management of investments and investment risks may need to be updated in anticipation of revised guidance and demonstrating that the policies and procedures are in line with its risk appetite and ESG strategy.
Triaging risks: A good risk management framework should identify, measure and monitor the impact of ESG risks. This involves starting to gather information on investments that are ‘high-risk’ from an ESG perspective, such as investments in fossil fuels, financial services, and software and information technology. Once identified, look into what the key risks may be and considering how those risks can be mitigated under an updated investment governance framework.

In order to measure and monitor ESG risks appropriately, RSE licensees should develop methodologies for due diligence and risk rating investments, conducting a risk assessment and monitoring to ensure that investments comply with policies and procedures (for example setting up ESG based investment limits and post-trade controls). Mitigating risks involves developing training and risk awareness programs, upskilling contractors and employees and performing ongoing monitoring of regulatory developments.
Stress testing updates: How stress testing programs may need to be updated to cover ESG risk factors, both of a broad nature (e.g. a significant adverse weather event occurring) and investment-specific nature (e.g. a significant data breach).
Monitoring APRA’s guidance process: Monitoring this issue carefully for developments, particularly for the release of the draft guidance for consultation later in 2022. RSE licensees should consider engaging with APRA during the consultation process, including by reviewing the draft guidance upon its release, considering the impact of the new guidance, and making submissions.
Revisiting arrangements with managers: Updating monitoring and reporting obligations in place in investment management agreements with managers. Due diligence questionnaires will likely also need to be updated to enable trustees to understand the approach to ESG risk management taken by managers and thereby assist the trustee to meet its bolstered obligations.