Navigating Financial Risks of Climate Change: Insights from Bank of Canada and OSFI's Climate Scenario Analysis Project
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November 5, 2023
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Navigating Financial Risks of Climate Change: Insights from Bank of Canada and OSFI's Climate Scenario Analysis Project

A recent climate scenario analysis pilot by the Bank of Canada and OSFI revealed key lessons for assessing climate-related..

Climate change poses an extraordinary risk to the financial system that demands immediate action. The Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI) have taken strides in this direction by conducting a pioneering climate scenario analysis pilot project in collaboration with major Canadian financial institutions.

This initiative has uncovered crucial findings for financial authorities, regulators, and institutions, as well as businesses, on effectively understanding and managing the risks arising from a transition to a low-carbon economy.

Climate Scenarios Unveil Need for Major Sectoral Overhaul

The Bank of Canada formulated a set of adverse scenarios in line with the Paris Agreement's objective of limiting global warming to below 2°C. These scenarios are hypothetical, not forecasts, and are premised on aggressive climate policy action and deep restructuring across sectors to achieve emissions reductions aligned with climate goals.

The analysis emphatically underscored the substantial transformations that high-emission sectors such as oil, natural gas, coal, electricity generation, transportation, heavy industry, and others may need to undertake to transition to a low-carbon economy.

The findings revealed that delaying climate policy action could exacerbate economic impacts and financial stability risks. The scenarios underlined the importance of orderly planning to prevent transition disorder, exemplified by the projected decline in net income for fossil fuel sectors compared to a baseline, while the electricity sector saw gains with the shift to renewable energy.

These scenarios underscore the uneven distribution of risks and opportunities across sectors in a climate transition. Some sectors will reap significant benefits, while others will grapple with existential threats.

The analysis also indicated potential risks of adverse GDP impacts for Canada's commodity-driven economy due to declining global demand for fossil fuels. As a major exporter, Canada is disproportionately vulnerable.

Evaluation of Climate Risk Exposures Unearthed Gaps in Data and Methodology

The participating institutions used methodologies developed by authorities to analyze credit and equity risks. The exercise exposed analytical gaps, despite the development of risk assessment capabilities.

The bottom-up credit risk analysis necessitated extensive subjective expert judgment by institutions, leading to highly varied results, highlighting the need for standardized practices.

The top-down market risk assessment offered more consistency, but was limited in sectoral granularity. Both approaches encountered difficulties in mapping exposures and projecting long-term horizons.

The collaboration between public and private sectors provided a valuable foundation, but also highlighted that the complexities of climate risks diverge significantly from traditional financial risks.

Key Takeaways for Advancing Climate Risk Monitoring and Assessment

The pilot project offered valuable insights for enhancing monitoring and assessment of climate-related financial risks.

These include the urgent need to develop consistent risk assessment standards, upgrade climate data collection, evaluate systemic interaction risks, and enhance system-wide monitoring capabilities.

With these improved capabilities, authorities will be better equipped to track the impact of climate risks on overall financial stability.

Both the Bank of Canada and OSFI have reiterated their commitment to further their work on climate financial risks. Their efforts will facilitate orderly transition planning and help to mitigate systemic risks.

Financial institutions should promptly incorporate adverse climate scenario analysis into risk management and strategic planning. Differences in vulnerabilities and opportunities will emerge across business lines and asset classes.

Companies must also expedite their disclosure of climate risks and decarbonization strategies. Transparent information on emissions profiles and reduction plans is essential for orderly transitions.

Policymakers play a crucial role in providing clear guidance and direction to facilitate the climate transition. Delayed and unpredictable policy escalates risks of financial disruption.

Successfully navigating the climate transition demands an unprecedented level of collaboration between authorities, financial institutions, and companies, as well as policymakers. The pilot project by the Bank of Canada and OSFI represents an important step forward on this challenging but necessary path.