Financial regulator warns of costly risks if climate action is delayed

Delaying climate action leads to increased risks to Canada’s economy and financial sector, warns an analysis published Friday by the Bank of Canada and the federal financial regulator, the Office of the Superintendent of Financial Institutions (OSFI).

The study outlines four scenarios ranging from the policies put in place at the end of 2019 to one that limits global warming to 1.5C – the goal that the Paris Agreement. He was careful to say that these scenarios are not forecasts or predictions, but different possibilities to help identify where the risks to the financial system might lie through the clean energy transition.

In all scenarios, significant changes are expected in the Canadian economy, and because the country has large carbon-intensive industries such as oil and gas, mining, and other heavy industries, the financial sector is intertwined with these industries and faces greater risks. as economies decarbonize.

The Bank of Canada and OSFI jointly launched this climate scenario analysis in November 2020, with input from six federally regulated financial institutions, including RBC, TD, Sun Life, Manulife, Intact Financial Corporation and Co-operators Group.

The study looked at the 10 most emissions-intensive industries in the economy, which account for 68 percent of Canada’s greenhouse gas emissions. It found that the six participating financial institutions had credit exposure totaling $239.3 billion. Banks accounted for about 55 percent of those exposures and insurers the other 45 percent. Credit exposure refers to what lenders would lose if the borrower defaulted.

Exposure to the oil and gas industry was the highest at 29.9 percent, with the power sector second at 29.2 percent given the amount of energy that is generated from fossil fuels. That means these energy-intensive sectors of the economy pose the greatest risk to financial institutions during the transition away from fossil fuels.

“Transition risks are of particular importance to Canada given its endowment of carbon-intensive commodities, the current importance of some of these carbon-intensive sectors to the Canadian economy, and the unique needs of the country as a vast northern country for heating. and transportation”. says the study.

what people are reading

“Timely and clear direction of climate policy and correct pricing of risks, supported by climate-related financial disclosures, go a long way to mitigating these risks.”

The report focused solely on risks related to the transition to a clean economy, meaning physical risks such as floods or wildfires were not included in the analysis. Bank of Canada and OSFI officials said studying how climate change will threaten assets is an area of ​​future work.

The University of Waterloo research professor of sustainable finance told Olaf Weber Canadian National Observer These types of scenario analyzes are relatively new to the financial industry, but because there are so many unknowns about what the transition will look like, financial institutions now recognize the need to plan for a variety of scenarios.

“Let’s say we want to meet the (climate) goals,” he said. “So we definitely have to burn less fossil fuels, and we have to produce less fossil fuels because a lot of Canadian emissions come from production.”

But “we have to understand that no matter how we do it, there will be consequences to the financial performance of these industries,” he added.

This is the heart of the problem for the financial industry. In Canada, since the Paris Agreement was signed, the Big Five banks (RBC, BMO, TD, CIBC and Scotiabank) have provided at least $694 billion to fossil fuel companies and invested another $125 billion directly. Banks want to see a return on their loans and investments, which means that energy policies that jeopardize the profitability of fossil fuels threaten banks’ bottom lines. But, as the Bank of Canada/OSFI report says, “delayed action leads to sharper transition” and sharper transitions mean higher risks.

Based on feedback from participants, among the report’s main findings was the need for more climate risk data and standardized reporting to guide investment decisions.

Weber noted that publicly traded companies already have standardized and regulated ways of disclosing financial information, but that doesn’t yet exist for emissions reporting. However, banks, as lenders, have the ability to demand better reporting if it is something they are concerned about, he added.

“On the one hand, they are right: we do not have any standardized mandatory reporting on climate risks or GHG emissions. But on the other hand, they could put more pressure on their customers (to) deliver that,” he said.

As environmental, social and governance disclosure reporting becomes a requirement, more data will become available, but Weber said risk management strategies will still be needed.

Weber applauded the report’s effort to spur a broader discussion on managing financial risks through a green transition, particularly for a country as risk-prone as Canada is, but said he would like to see action intensified.

“We are starting now with risk assessment, and perhaps the next step is to generate standardized indicators,” he said.

With standardized ways to assess risk, it can be more easily identified. Once a risk is identified, financial institutions can pressure companies to make changes, he said.

On Friday, OSFI also published a letter federally regulated financial institutions outlining the work it will do this year to improve awareness of climate-related financial risks.

Initiatives include publishing a climate risk management guidance document, studying data gaps, and building on the scenario analysis released Friday with more work. Additional work includes studying capital and liquidity to manage climate risks, looking at climate-related financial disclosures, working “domestic and international” with other stakeholders “inside and outside the financial industry,” and building capacity from the agency itself through its climate risk center.