Last week, the Bank of Canada (the BoC) and the Office of the Superintendent of Financial Institutions (OSFI) released their joint final report on their pilot climate scenario analysis project titled Using Scenario Analysis to Assess Climate Transition Risk. According to the BoC and OSFI "[the] pilot was an important step in helping Canada's financial sector improve its ability to analyze economic and financial risks affecting financial institutions that could arise from climate change."
In late 2020, the BoC and OSFI jointly launched a climate scenario analysis pilot (the Pilot) to better understand the risks to the financial system that could arise from a transition to a low-carbon economy, or "transition risk". Transition risk is the risk inherent in changing strategies, policies or investments as society and industry work to reduce their reliance on carbon and the impact on our climate.
For the Pilot, the BoC and OSFI partnered with six Canadian financial institutions (the Co-operators Group Limited, Intact Financial Corporation, Manulife Financial Corporation, Royal Bank of Canada, Sun Life Financial and TD Bank Group – the FIs).
The FIs analyzed and assessed credit and market risk related to selected elements of their balance sheets related to the transition to a net-zero/low-carbon economy. The insurer FIs analyzed credit risk to their bonds and corporate loans portfolios and market risk to their equity portfolios, whereas the bank FIs analyzed credit risks to their wholesale loans portfolios.
According to the BoC and OSFI, the objectives of the Pilot were to:
- build the capability of regulatory authorities and FIs to do climate transition scenario analysis;
- support the Canadian financial sector in improving its assessment and disclosure of climate-related risks; and
- contribute to the understanding of the potential exposure of the financial sector to climate transition risk.
What is climate change scenario analysis?
Climate change scenario analysis allows financial institutions to better understand and quantify the risks and uncertainties they may face under different hypothetical climate futures. The Pilot considered four climate scenarios over a 30-year horizon (from 2020 to 2050):
- baseline (2019 policies) — a baseline scenario consistent with global climate policies in place at the end of 2019.
- below 2°C immediate — an immediate policy action toward limiting average global warming to below 2°C.
- below 2°C delayed — a delayed policy action toward limiting average global warming to below 2°C.
- net-zero 2050 (1.5°C) — a more ambitious immediate policy action scenario to limit average global warming to 1.5°C that includes current net-zero commitments by some countries.
Lessons learned from the pilot
According to the BoC and OSFI:
- The Pilot provided both financial authorities and participating financial institutions with a foundational experience in using climate scenario analysis to identify, assess and understand climate-related transition risks to the Canadian economy and financial system.
- The different climate scenarios employed for the Pilot outlined a number of potential material risks to the economy and the financial system.
- The analysis concluded that, while every sector needs to contribute to the climate change transition, negative financial impacts emerged for some sectors (e.g., fossil fuels) and benefits emerged for others (e.g., electricity).
- Finally, the analysis showed that delayed climate policy action increases the overall economic impacts and the risks to financial stability of a sudden repricing of assets.
BoC and OSFI's next steps
According to the report, the BoC and OSFI plan to further expand the Pilot to include:
- assessment and analysis of "physical risk", such as the risk posed from increasing the frequency of extreme weather events due to rising average temperatures
- expanding the scope of the analysis to include other financial institutions and other assets
- exploring systemic risk considerations, and
- working toward improving and standardizing risk assessment methodologies.
While pension plans were not a part of the Pilot, and no mention was made of expanding the Pilot to pension plans at this time, climate change scenario analysis is a tool that pension plan administrators could use to assess and monitor climate change risk. Indeed, certain activist groups appear to be advocating for scenario analysis as part of an administrator's fiduciary duty. While neither regulators nor courts have taken a position on scenario analysis to assess climate risk, it is a tool in an administrator's tool kit. As guidance from pension regulators on ESG and climate change in particular evolve, it is likely that scenario analysis will play a role.
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