Stress-testing the impact of climate change on Canada’s financial system

The Bank of Canada (BOC) and the Office of the Superintendent of Financial Institutions (OSFI) and a small group of volunteer financial institutions will conduct a pilot project to evaluate the possible effects of climate change and the transition to a low-carbon economy on Canada’s financial system and institutions. The project will use scenario analysis to stress test participating financial institutions to evaluate their exposure to the risks of climate change and the transition to a low-carbon economy.

What you need to know

• The pilot project will be a key step in tailoring existing climate change scenario analysis models to the Canadian context where transition risks loom especially large due to the size of the resource sectors relative to the economy as a whole. These “Canadianized” models may provide a standardized means for financial institutions, investors, and regulators to assess the exposure of Canada’s financial institutions to climate change-related risks.
• Climate change scenario analysis seems poised to become a required element of the disclosure framework of financial institutions, as the pilot project is part of a growing emphasis on climate and ESG-related disclosure as evidenced by initiatives such as the Task Force on Climate-related Financial Disclosures (TCFD) and the growing investor demand for ESG investment products.
• For financial institutions that not have already begun preparing to undertake climate change-related scenario analysis, the launch of the pilot project suggests that now may be the time to begin to prepare for the next stage in the evolution of climate change-related regulation and disclosure.

Overview of the pilot project

On November 16, 2020, the Bank of Canada (BOC) and the Office of the Superintendent of Financial Institutions (OSFI) announced that they, along with a small group of volunteer financial institutions, will conduct a pilot project to evaluate the possible effects of climate change and the transition to a low-carbon economy on Canada’s financial system and institutions. According to the BOC, the goals of the project are threefold:

• build the climate scenario analysis capability of authorities and financial institutions, and support the Canadian financial sector in enhancing the disclosure of climate-related risks;
• increase authorities’ and financial institutions’ understanding of the financial sector’s potential exposure to risks associated with a transition to a low-carbon economy; and
• improve authorities’ understanding of financial institutions’ governance and risk-management practices around climate-related risks and opportunities

Scenario analysis is a familiar tool, typically encountered, for example, in the form of stress tests of a bank’s ability to withstand negative economic shocks under a range of hypothetical scenarios. Such testing enables regulators and financial institutions to better understand and prepare for the risks to financial institutions and systems posed by negative shocks. Climate change scenario analysis has similar goals, but unlike economic stress tests, must rely on forward-looking models to construct the scenarios used in the analysis.

International activities

The BOC-OSFI project is one of a number of similar initiatives being undertaken by central banks, regulators and financial institutions to assess the potential impacts of climate change on financial systems and institutions. The Network of Central Banks and Supervisors for Greening the Financial System (NGFS) has led the way in developing a common framework for country-level institutions to assess and prepare for the consequences of climate change and the transition to a low carbon economy¹. The NGFS has developed a set of three representative scenarios that explore the consequences of three policy responses to climate change:

• the orderly scenario, which assumes aggressive climate policies in the short term, and a smooth transition to a low-carbon economy in line with the Paris Agreement greenhouse gas emission reduction targets;
• the disorderly scenario, which assumes that climate change policies are delayed until 2030 with a consequent abrupt transition to the goals of the Paris Agreement; and
• a hot house scenario, which assumes that only existing climate change policies are put in place and global temperatures rise by three degrees or more.

Central banks and regulatory bodies have contributed to and built upon this work. For example, the BOC has published a number of preliminary papers in which it has explored the use of existing climate-economy models used in other contexts for use in climate-related scenario analysis². In Europe, the Autorité de Contrôle Prudentiel et de Résolution (ACPR) in France³ and the Bank of England are undertaking work similar to that of the BOC and OSFI. The ACPR has launched a climate pilot exercise to assess the physical and transition risks posed by climate change to financial institutions. The ACPR project has incorporated the work of the NGFS and developed various scenarios for use by financial institutions participating in the study to conduct a bottom-up climate assessment. Likewise, the Bank of England is in the process of testing several prominent banks and insurers for their exposure to the physical and transition risks of a range of climate scenarios. This “Biennial Exploratory Scenario” exercise will use a set of scenarios similar to those of the NGFS to assess the resilience of UK banks and insurers over a thirty-year period to the physical and transition risks of climate change.

Conclusion

Both in Canada and abroad, climate change scenario analysis of financial institutions is in its early days. Central banks and regulators (see our earlier guidance here) are increasingly providing the tools, such as the disclosure standards of the Task Force on Climate-related Financial Disclosures (TCFD), and impetus for individual financial institutions to assess and disclose their risk exposure to the physical and transition risks of climate change (see more in our bulletin on the growth of sustainable finance here). This top-down pressure is likely to be complemented by ever increasing bottom-up pressure from investors for increased disclosure relating to these risks. ESG-based investing has proven to be highly resilient during the COVID-19 pandemic as compared with other investing approaches: the results of scenario analyses such as those to be conducted in the BOC-OSFI project may come to be an expected part of an institution’s disclosures alongside traditional metrics of performance.

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¹ Broadly speaking, climate change risks fall into two categories: physical, arising from the chronic (e.g. sea level rise, desertification) and acute (e.g. storms, and floods) impacts of climate change, and transition risks that arise from the structural changes (such as regulatory and market changes) consequent upon a move to a low-carbon economy. The materialization of these risks can affect the financial system as a whole, for example, through stranded assets and infrastructure damage can affect GDP and productivity, and individual institutions, for example, through reduced profitability and asset values.

² For example, see Staff Discussion Paper 2020-3 “Scenario Analysis and the Economic and Financial Risks from Climate Change”.

³ The ACPR is the independent administrative authority responsible for monitoring the conduct of financial institutions in France, as well as protecting the French financial system from money laundering and terrorist financing.

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