Every scenario paints the same picture: The climate transition will create significant risks for some economic sectors. This is one of the findings presented in the report Using Scenario Analysis to Assess Climate Transition Risk, published in January 2022 by the Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI)
The transition will be more difficult in countries with large carbon-intensive sectors, such as Canada. All sectors must contribute to the transition, yet some will suffer strongly negative financial impacts, the report says. At the same time, sectors such as the electricity sector will benefit from the transition.
“The results of the climate scenario analysis also shed light on the risks of significant macroeconomic impacts, driven largely by global channels and of particular significance for commodity-exporting countries like Canada,” the report reads. The authors attribute the impacts primarily to lower global commodity prices.
Four insurers and two banks
The report is the result of a scenario analysis pilot project involving six financial institutions. They include two P&C insurers, The Co-operators and Intact Financial Corporation, two life insurers, Manulife and Sun Life, and TD Bank and RBC Royal Bank.
The Bank of Canada and OSFI developed these scenarios to illustrate the potential consequences of shifting to a “low-carbon” world. The scenarios also depicted the types of stress that could emerge within the financial system and economy during the course of the transition.
The two organizations that produced the report said they hope the pilot project will help the financial sector develop resources and capacity to assess and disclose climate-related transition risk.
Next focus: Physical risks
Looking ahead, the report says that efforts will be needed to improve data collection on exposures and vulnerabilities. The physical risks of climate change are another area worth exploring, as are other types of risks or broader systemic considerations, the report adds.
Bank of Canada Deputy Governor Toni Gravelle says the Bank has committed to develop new models and methods to better understand the physical and transition effects of climate change on the Canadian economy.
The Bank of Canada plans to build its capacity to assess the implications of more frequent extreme weather events, and the transition to a low-carbon economy for potential output growth, the labour market and inflation.
The scenario analysis also concludes that financial institutions need to have more rigorous financial risk management practices linked to climate change. “Climate scenario exercises, like this one, make clear the potential financial impacts of climate-related transition risks across a range of different climate pathways,” says Ben Gully, OSFI's Assistant Superintendent.
Gully believes that these scenarios are a critical step toward building risk management capability and awareness among regulated entities. They thus promote financial system resilience through the transition.
OSFI intends to issue a draft guideline on climate risk management for federally regulated financial institutions (FRFIs) during 2022. The Office wants to see FRFIs achieve five prudential outcomes:
Climate-related financial risks and their implications are understood throughout the FRFI.
- Governance and strategy
The institution embeds climate-related financial risks into its overall strategy and risk appetite, integrates these risks into its risk governance regime, and ensures appropriate management and oversight.
- Risk management
The FRFI integrates material climate-related financial risks into its enterprise risk management processes and manages them accordingly.
- Financial resilience
The institution remains adequately capitalized and liquid through severe yet plausible climate risk scenarios over extended horizons.
- Operational resilience
The FRFI continues to deliver critical operations through disruptions due to climate-related disasters.