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Climate transition risk and financial institutions

February 24, 2022

Climate transition risk and financial institutions

Synopsis
10 Minute Read

Canada's financial institutions are uniquely exposed to risk as domestic and global economies seek to address climate change. The results of a federal pilot project shed light on how the financial sector is responding, and the necessary steps to thrive in a net zero business environment.

Leader, Environmental Social & Governance and Regional Leader, Enterprise Risk Services

Contents


Federal pilot project highlights the challenges and opportunities for Canada in a de-carbonizing global economy

Given their central role in Canada’s business community, financial institutions face uncommonly broad exposure to global efforts to decarbonize and address climate change. Not only must each institution consider its own sustainability goals, but also those of businesses across all sectors to whom their performance is tied in the form of loans, securities, and investment portfolios.

The future is indeed uncertain for the Canadian banking sector, with open questions around domestic and international regulatory frameworks, how technology will evolve and support the path to net-zero, and how various businesses will respond to the challenge. It is for these reasons the domestic financial sector faces perhaps the murkiest road ahead — though a recent pilot project is beginning to provide some visibility.

The Bank of Canada (BoC) and the Office of the Superintendent of Financial Institutions (OSFI) released the highly anticipated results of a climate scenario analysis pilot project in January 2022. With Canada being a significant commodity-exporting country, this analysis forms an essential foundation to evaluate how global decarbonization will alter demand for Canadian commodities.

Their final report, Using Scenario Analysis to Assess Climate Transition Risk[1], was supported by two technical papers — one focused on transition scenarios[2] and another on implementation methods[3]. All three documents collectively paint a clearer picture of the nation’s greenhouse gas emissions, efforts to reduce our carbon footprint, as well as the implications of changing capital expenditures and the associated cost of capital.

In other words, how will domestic and international climate targets alter the Canadian economy?

Along with the pilot project results, the BoC and OSFI also released the underlying climate transition scenario data[4]. This initial work is a strong step forward in arming financial institutions with a better understanding how climate transition could affect the Canadian economy through three main channels:

  1. the domestic carbon pricing scheme and other domestic carbon-reduction policies,
  2. reduced foreign demand for Canadian goods following the implementation of similar policies in other countries due to slower global economic growth, and
  3. lower commodity prices received by Canadian producers.

While insightful, the BoC and OSFI have cautioned data gaps remain in their findings. More investigation is necessary to understand the true impacts of climate-related transition plans on the Canadian economy and the financial sector. Aside from additional time and investment, study authors also noted the need for a standardized methodology to conduct a more meaningful evaluation, improve climate-related data, and provide consistency and comparability between all players.

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Background

The BoC released a report[5] in 2019 examining the threat of climate change to the country's financial system. The following year, it announced plans for a pilot project with OSFI to better understand the risks of transitioning to a low-carbon economy using a range of climate change scenarios. In 2021, OSFI completed a study[6] which publicly recognized the risks of climate change and the potential material implications to financial institutions’ assets and profitability.

OSFI has a mandate to drive public confidence in the Canadian financial system, while the BoC is responsible for influencing monetary policy. Both institutions’ respective domains face great potential impacts as the pursuit of more sustainable companies and communities remains the number one global agenda item — and climate-related risks and opportunities continue to trickle through financial systems.

While the social and governance pillars of Environmental, Social, and Governance (ESG) are equally critical to the long-term sustainability of any financial institution (including the Canadian economy), the BoC / OFSI study focused solely on the environmental pillar.

Looking at the pilot project itself, six Canadian financial institutions participated: two banks, two life insurers, and two property and casualty insurers. The project had three fundamental aims:

  1. Build climate scenario analysis capability within authorities and financial institutions and support the Canadian financial sector in enhancing the disclosure of climate-related risks.
  2. Increase authorities’ and financial institutions’ understanding of the financial sector’s potential exposure to risks associated with a transition to a low-carbon economy.
  3. Improve authorities’ understanding of financial institutions’ governance and risk-management practices around climate-related risks and opportunities.

OSFI has categorized climate-related risks into three buckets:

  • Physical risk — “which arises from a changing climate increasing the frequency and severity of wildfires, floods, wind events and rising sea levels, among other things.”
  • Transition risk — “which stems from efforts to reduce greenhouse gas (GHG) emissions as the economy shifts towards a lower-GHG footprint.”
  • Liability risk — “which relates to potential exposure to the risks associated with climate-regulated litigation.”[7]

The BoC / OSFI pilot project focused primarily on transition risk. However, this should not dissuade financial institutions from assessing the equally important physical risks of climate change which interact directly with transition risk.

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Key findings

The BoC / OSFI report revealed financial institutions are in the early stages of both understanding the need for climate-related risk assessment and scenario planning capabilities and building these out in earnest. The report also reinforced the complexity of climate-related transition risk analysis. This is not surprising given the numerous factors influencing outcomes of national and global climate commitments which include:

  • the extended time horizon for policy to evolve
  • difficulties in predicting how technology and socio-economic factors will change, when those changes will occur, and the impacts of those changes
  • challenges in aligning time-sensitive assessments with the accelerating pace of change, and
  • the need for business model sensitivity analysis and stress testing to reassess historic perspectives of stability in the context of macro influences on the Canadian economy.

Considering the study analyzed four climate scenarios over a 30-year time horizon, the variability in its findings make sense. It’s difficult to pin down the timing and ambition of global climate policy, as well as the pace of technological change; even subtle nuances can result in large swings over a long timeline. The study captured this, highlighting the need for continued work to standardize assessment methodologies, improve data collection efforts, and incorporate systemic risk considerations into the ongoing analysis.

At a minimum, the present analysis shows risks intersect a broad range of stakeholder interests across the private and public sectors:

“In addition to central banks and governments, these risks could affect financial institutions, resource-intensive industries and other private sector firms. As such, public and private sector institutions may need to step up their analysis of these risks.”[8].

Following are key study findings which will be of particular concern to financial institutions and the private sector.

Governance

All six pilot participants had established various board committees with responsibility to oversee management of climate-related risks. Some created committees solely dedicated to climate-related risks, while others embedded climate risks in committees overseeing a broader range of risk issues.

This is noteworthy because ownership of climate-related risks and opportunities is critical at the board level — including the full ESG strategy to drive value and build resilience for the Canadian economy.

Risk management

Few pilot participants identified or incorporated quantitative climate-related risk measures into their risk management framework — and most were unable articulate key risk indicators or associated limits.

This highlights a need to better link climate and reputational risks, given that violating environmental regulations or other best practices can lead to significant exposure. Greater scrutiny on high-emitting sectors is also critical to understand implications, as well as evaluate current business practices, lending, and investment activities in these areas.

Opportunity management

No assessment of climate-related risks is complete without also understanding the associated opportunities. There is a strategic upside in identifying opportunities to invest in renewable energy or sustainable real estate determining how best to connect customers with sustainable finance products and services. Essential is the inclusion of climate-related opportunities into the strategic planning process and final strategic objectives.

Targets

Of the six pilot participants, most had already set operational targets related to greenhouse gas emissions, use of renewable energy sources, and carbon-related asset metrics. This included more strategic, long-term net-zero commitments between now and 2050.

All financial institutions should be questioning whether they have evaluated targets and whether these are applicable to their own roadmap to net zero.

Reporting

All six pilot participants had committed to the Task Force on Climate-related Financial Disclosures (TCFD) recommendations to disclose clear, comparable, and consistent information about climate-related risks and opportunities. This included annual ESG reporting which detailed climate-related activities and achievements.

With this comes the need for assurance on disclosures to enhance reliability. The study noted some pilot participants had already obtained limited independent assurance on some components of their reporting. However, universal adoption still appears a long way off.

Velocity

Sudden changes in climate policies, technology, or market sentiment could lead to a material reassessment of the value of a variety of financial assets. As described in the report:

“A late and abrupt transition to a low-carbon economy could lead to assets suddenly losing value and a rapid repricing of climate-related risks if they are not already sufficiently priced in by market participants. In turn, this could negatively affect the balance sheets of financial market participants, with potential consequences for financial stability."

Transition risks stemming from efforts to reduce GHG emissions are of particular significance given:

  • Canada’s abundance of carbon-intensive commodities,
  • the importance of carbon-intensive sectors in the Canadian economy, and
  • Canada’s unique demand for carbon-intensive heating, electricity, and transportation resources as a vast northern country.

Timely and clear climate policy direction and the correct pricing of risks, supported by climate-related financial disclosures, will be essential to mitigate these risks.

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Key takeaways for financial institutions

Despite the variability and need for further, more standardized analysis, the BoC / OSFI study has highlighted several priorities and considerations financial institutions can begin applying immediately. Following are some immediate steps financial institutions can begin taking to better account for the transition risk that comes with changes in a low carbon economy: 

1. Board roles and responsibilities

Use the board’s governance and oversight responsibilities to position ESG as a clear priority and set expectations for the near- and long-term transition to a low-carbon economy. Create committees to investigate high-level risks and priorities, as well as audit and oversee management progress toward climate transition objectives. Work with management and executive teams to approve ESG benchmarks and success factors and identify emerging challenges.

Set clear expectations for what each group needs to achieve and how to measure success. Include these responsibilities on the agenda at board meetings to evaluate progress and discuss emerging challenges

2. Management roles and responsibilities

Management should be responsible for addressing the climate-related risks arising from business activities, which includes dedicating resources (i.e., people, budget, consultants, etc.) for these accountabilities.

Define and document expectations for each individual responsible for maturing ESG efforts. This includes accountabilities for identifying, assessing, measuring, monitoring, and reporting climate-related risks — as well as implementing in-house capabilities to effectively analyze physical and transition risks.

3. Credit exposures

Understand ESG-related credit exposure for each sector across the loan portfolio. Assess potential impacts and changes to strategy and risk management that will result from decarbonization and sustainability-related transitions.

4. Risk management

Identify standalone climate-related risks where warranted, but also integrate elements of these risks in other applicable categories such as strategic, credit, market, and operational risk.

5. Internal audit

As the third line of defense, internal audit should provide an independent review of risk management controls, processes, and systems. It should also report on the effectiveness of the first (i.e., management) and second (i.e., risk management) lines of defence functions.

The annual internal audit plan should incorporate climate-related risks either as specific audits or, preferably, integrated into each audit as part of the greater ESG paradigm.

6. Data governance

Develop a holistic data governance strategy that is inclusive of climate-related risks. This should include any necessary adaptations to information technology systems for data collection, aggregation, and analytics.

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Preparation is the best risk management

Transition risk doesn’t only impact financial institutions, but a broad range of stakeholders across the private and public sectors. As outlined in the BoC / OSFI report:

“In addition to central banks and governments, these risks could affect financial institutions, resource-intensive industries and other private sector firms. As such, public and private sector institutions may need to step up their analysis of these risks.”[9]

It’s clear the status quo is not a sustainable option. Change is coming, whether institutions are prepared for it or not. It is time to step up, analyze, and strategize for a different future state. Indeed, this is the only way to soften the brunt force of change — and make the most of the opportunities it affords.

Learn more about ESG

To learn more about ESG and how it impacts your business contact Edward Olson.

[1] https://www.bankofcanada.ca/wp-content/uploads/2021/11/BoC-OSFI-Using-Scenario-Analysis-to-Assess-Climate-Transition-Risk.pdf).

[2] https://www.bankofcanada.ca/2022/01/staff-discussion-paper-2022-1/

[3] https://www.bankofcanada.ca/2022/01/technical-report-120/

[4] https://www.bankofcanada.ca/2022/01/climate-transition-scenario-data/

[5] https://www.bankofcanada.ca/2019/05/financial-system-review-2019/

[6] https://www.osfi-bsif.gc.ca/Eng/fi-if/in-ai/Pages/clmt-rsk-let-1021.aspx

[7] https://www.osfi-bsif.gc.ca/Eng/Docs/clmt-rsk.pdf

[8] https://www.greenfinanceplatform.org/policies-and-regulations/bank-canada-conducted-climate-related-scenario-analysis

[9] https://www.greenfinanceplatform.org/policies-and-regulations/bank-canada-conducted-climate-related-scenario-analysis

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