On January 14, 2022, the Bank of Canada ("BoC") and the Office of the Superintendent of Financial Institutions ("OSFI") published Using Scenario Analysis to Assess Climate Transition Risk, the Final Report of the BoC-OSFI Climate Scenario Analysis Pilot (the "Final Pilot Report"). The Final Pilot Report is the culmination of a pilot project launched in November 2020 (the "Pilot") to better understand risks to the Canadian economy and financial system related to the transition to a low-carbon economy, by developing scenarios to analyze the potential exposure of Canada's financial sector in the context of different pathways towards achieving specific climate targets. Two technical papers (Transition Scenarios and Implementation Methods) and the climate scenario data developed for the Pilot were released concurrently with the Final Pilot Report.
Six Canadian financial institutions - including two banks, two life insurers, and two property and casualty insurers - participated in the Pilot, the results of which are the primary focus of the Final Pilot Report.1 The Final Pilot Report also includes the results of a survey of these six Pilot participants, as well as the takeaways from a questionnaire provided to a broader range of financial sector stakeholders to better understand their preparedness for climate-related risks. The Final Pilot Report also sets out matters for future analysis identified as a result of conducting the Pilot.
The scenarios reflect the sectoral restructuring the Canadian and global economies may need to undertake to meet climate targets. Notably, the Final Pilot Report identifies potential macroeconomic impacts on the Canadian economy due to the importance of commodity exporting, which may be particularly affected by global climate policy. While economic risks may be posed by domestic policy changes, risks stem primarily from transitions in global policy. A delay of any climate policy action, however, also increases the overall economic impacts and risks to stability of the financial sector.
Scenario analysis, which is the substantive basis for the Pilot, is a subject of increasing focus in climate-related policy discussions in Canada. The Canadian Securities Administrators are currently accepting public comments on a series of questions related to its proposed National Instrument 51-107 - Disclosure of Climate-Related Matters ("NI 51-107"), one of which concerns the use of scenario analysis. The recent Federal Mandate Letters also include objectives concerning the recommendations of the Task Force on Climate-Related Financial Disclosures ("TCFD"), which include the use of climate change scenario analysis. Globally, scenario analysis may also be included in the future baseline sustainability standards that will be developed by the International Sustainability Standards Board ("ISSB"). Our review of those developments can be found here, here, and here, respectively.
While scenario analysis in the climate context is still in its infancy, insurers and banks in Canada are already accustomed to this type of analysis as a risk management technique which is routinely used in the regulatory context to evaluate current liquidity and capital base needs and to inform liquidity and capital management (albeit over a shorter time horizon).2 The Final Pilot Report, however, points out that the Pilot was not a climate stress test or a capital adequacy prudential exercise.
Both BoC and OSFI are members of the international Network for Greening the Financial System ("NGFS"), a network of more than 100 central banks and regulatory supervisors (including the U.S. Federal Reserve) focused on developing climate risk management best practices, which we discussed here. As demonstrated by a recent report of the NGFS, Canada is not alone in taking a more serious look at scenario risk analysis. Central banks and supervisors from 31 members of the NGFS (including key trading partners of Canada such as England, France, Germany, China, and Mexico, among others) are in varying stages of implementing their own similar scenario analysis exercises. Scenarios used in the Pilot are aligned with scenarios developed by the NGFS to which BoC contributed.
As the BoC and OSFI consider the impact of climate change on Canada's financial sector, the Final Pilot Report contributes to the development of their capacity to understand and assess the effects of climate-related risks. OSFI published its discussion paper Navigating Uncertainty in Climate Change: Promoting Preparedness and Resilience to Climate-Related Risks in January 2021. The Final Pilot Report states OSFI will follow up on that discussion paper by developing prudential guidance on risk management expectations, scenario analysis and disclosure.
The Purpose of the Pilot
The Pilot had three principal stated objectives:3
- to build the capabilities of authorities and financial institutions in climate scenario analysis and help the Canadian financial sector improve its assessment and disclosure of climate-related risks;
- to increase understanding of the financial sector's potential exposure to a range of risks that may come with a transition to a low-carbon economy; and
- to improve authorities' understanding of financial institutions' governance and risk management practices around climate-related risks and opportunities.
The underlying imperative for these objectives is the broader need to understand the impacts of climate change on Canada's economy and financial system. As recognized in the Final Pilot Report, climate change "looms as a potentially large structural change" that may impose both physical risks (such as flooding and wildfires) and economic transition risks (such as sudden changes in policy).
The Pilot focused on economic transition risks, which are particularly salient in Canada due to the economic importance of the carbon-intensive sectors to the economy. Scenario analysis may be a valuable tool in identifying, assessing and understanding climate-related transition risks to the Canadian economy and financial system.
What is Scenario Analysis and how was it used in the Pilot?
Scenario analysis is a process of examining and evaluating possible future developments in order to conduct a forward-looking risks and opportunities assessment. Each scenario considered includes a plausible course of action leading to a specific future outcome. Notably, the purpose of scenario analysis is not to forecast the most probable scenario but rather to consider an array of "what if" possibilities. Scenario analysis is considered a valuable tool for assessing climate-related risks due to their inherent complexity and array of variable factors. It is included in the TCFD recommendations and used by a number of central banks and regulators around the world, and is increasingly common amongst private sector stakeholders.
The Pilot participants considered risks to certain elements of their balance sheets related to the transition to a net-zero or low-carbon economy:
- Banks: Credit risk to their wholesale loans portfolio;
- Insurers: Credit risk to their bond and corporate loan portfolios, and market risk to equity portfolios.
The Pilot's scenario analysis focused primarily on Canadian and US exposures, and considered the 10 most emissions-intensive sectors of the Canadian economy (accounting for approximately 68% of Canada's greenhouse gas emissions): crops, forestry, livestock, coal, crude oil, gas, refined oil, electricity, energy-intensive industries and commercial transportation.
Four NGFS-aligned scenarios, each intentionally adverse and set over a 30-year horizon (2020-2050), were developed for the Pilot. The scenarios varied levels of the ambition and timing of global climate policy, as well as the pace of technological change:
- Baseline: Global climate policies remain consistent with those in place at the end of 2019, with limited technological change;
- Immediate: Action is immediately taken to limit average global warming to below 2°C, with moderate technological change;
- Delayed: There is a delay until 2030 in action taken to limit average global warming to below 2°C, with moderate technological change; and
- Net-zero: Action is immediately taken to limit average global warming to 1.5°C, including current net-zero commitments by certain countries, with rapid technological change (including moderate availability of carbon dioxide removal technologies, which are limited in the preceding scenarios).
Carbon pricing plays an important role in each scenario analysis, with the Pilot's modelling approach using a "shadow price of carbon". This involves calculating the marginal carbon price that would be required to achieve certain emissions reductions after considering non-carbon price policies/measures.
Scenario Analysis Highlights in the Final Pilot Report
The Final Pilot Report identifies a number of findings that emerged from the scenario analysis. First, a delay in the timing of any kind of global climate policy action will require sharper transitions (i.e., higher shadow-carbon pricing) to reduce emissions in order to make up for lost time. Smoother transitions will result from more immediate action.
Second, carbon pricing will make certain energy commodities more expensive, leading to a reduction of emissions in each of Canada's top-ten emissions-intensive sectors in order to meet the varied climate targets.
Third, while the financial impacts in each scenario vary across sectors, the sectors fell within three broad groups:
- sectors experiencing a decline in demand as economies decarbonize (g., oil and gas);
- sectors experiencing a rise in demand through the economic transition (g., electricity); and
- sectors experiencing challenges associated with increased emissions costs and/or capital costs to mitigate exposure to the transition.
In particular, the Final Pilot Report notes that Canada's electricity sector is well positioned due to its relatively high proportion of renewable generation assets, which supports electrification of the Canadian economy.
Fourth, the GDP of Canada is materially impacted in each of the scenarios primarily due to global factors, which could: 1) lower foreign demand for goods and services, and 2) lead to a decline of global commodity prices, particularly affecting fossil-fuel producing sectors.
Fifth, and unsurprisingly, the borrowers in the more negatively affected sectors had a larger increase in their credit risk, in their probability of default (we previously discussed carbon-related credit risk here). Electricity, for example, saw a negligible change in credit risk whereas other sectors saw the probability of default by 2050 increasing substantially.4 Certain sectors also had variation in risk among their constituent segments. The Final Pilot Report similarly found an uneven impact across sectors in respect of the market risks to equity portfolios, with the electricity sector experiencing equity valuation gains while negative impacts were observed in the fossil-fuel sectors.
The Governance and Risk Management Practices of Pilot Participants
In addition to the results of the climate change scenario analysis, the Final Pilot Report contains a summary of key themes that emerged from the results of a survey of the Pilot participants' governance and risk management practices relating to climate-related risks. Participants reported on their current controls and practices across the following five areas:
- Governance: The Pilot participants generally have climate-related risks incorporated into their established risk appetite frameworks as well as board committees tasked with overseeing the management of climate-related risks. Senior management are actively involved in the management of climate-related risk, and the governance process is reviewed regularly.
- Business Models and Business Strategy: Each Pilot participant has undertaken efforts to better understand their climate-related risks and opportunities. With respect to risks, the Pilot participants have started to impose restrictions on lending or investment for certain high-emitting sectors. Pilot participants have also explored climate-related opportunities.
- Risk Management Oversight: Climate-related risks are identified as a top risk by each of the Pilot participants. Some of the Pilot participants have incorporated climate-related risks, to some extent, into their "three lines of defence" approach to risk management as described in the Final Pilot Report.
- Risk Management Framework: The Pilot participants are in the early stage of developing their capability to incorporate climate-related risks as drivers in their risk management frameworks. Physical risk was better understood by the Pilot participants than transition risk, although the Pilot advances their understanding of transition risk.
- Reporting And Disclosure: Each of the Pilot participants are committed to aligning their climate-related disclosures with the TCFD recommendations, recognizing the need to have robust reporting and disclosure practices.
OSFI also provided a questionnaire to a broader range of financial sector stakeholders, which included small- and medium-sized financial institutions, asset managers, pension plans, industry associations, rating agencies, and other service providers. The results of the questionnaire are summarized in the Final Pilot Report and provided insights on the capacity for preparedness, governance, and disclosures related to climate change.
What Comes Next after the Final Pilot Report?
The Final Pilot Report concludes that climate scenario analysis is a new and growing field that may be of considerable value to Canadian participants in the financial sector. Based on the findings of the Final Pilot Report, the BoC and OSFI have identified certain subjects that will require further exploration. Future efforts will attempt to address current analytical limitations by:
- incorporating physical risks;
- expanding the scope of the analysis to other financial institutions and assets;
- exploring systemic risk considerations; and
- improving and standardizing risk assessment methodologies.
As noted, OSFI intends to issue prudential guidance on risk management expectations, scenario analysis and disclosure in the near term. Combined with the Final Pilot Report, this is expected to provide Canadian financial institutions with foundational support in using scenario analysis to understand and respond to climate-related risks in the Canadian economy.
The Bottom Line
The Final Pilot Report is an important milestone in the Canadian financial sector's efforts to address the impacts of climate change. In particular, the use of climate change scenario analysis by the BoC and OSFI, despite some of its existing challenges as a tool that is in the early stages of development, signals that Canadian regulators are committed to gauging the financial and economic effects of climate change and related policy on the economy.
The Final Pilot Report also brings the use of scenario analysis into discussion at a critical time in the development of climate-related policy in Canada. Although scenario analysis is included in the TCFD recommendations, it is excluded from the proposed NI 51-107 which otherwise substantially conforms with those recommendations. The proposed NI 51-107 is currently subject to a public consultation period that ends February 16, 2022.
Further, scenario analysis may be included in the future global baseline sustainability standards that will be developed by the ISSB, which will have its second office located in Montreal (as we discussed here). Canadian public issuers and financial institutions may therefore consider proactively adopting scenario analysis sooner rather than later.
Finally, while the Final Pilot Report focuses on transition risks related to climate change and global climate policy action, it simultaneously demonstrates that there are opportunities across the Canadian economy to not only begin mitigating plausible adverse impacts but to prepare for unique opportunities arising from the transition to a low-carbon economy.
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1. The participants were, respectively, Royal Bank of Canada, TD Bank Group, Manulife Financial Corporation, Sun Life Financial, Co-operators Group Limited, and Intact Financial Corporation.
2. See, for example, OSFI's Guideline E-19 Stress Testing; OSFI's Guideline E-19 Own Risk and Solvency Assessment; and OSFI's Guideline E-19 Internal Capital Adequacy Assessment Process (ICAAP) for Deposit-Taking Institutions.
3. The Pilot focused exclusively on the transition risks of climate change. The Final Pilot Report noted that while it is equally important to assess the physical risks of climate change and the interaction between physical and transition risks, they have left that to future work. Notably, the Pilot did not consider potential impacts on liability risks.
4. See The Final Pilot Report, page 31-32, Chart 16 and Chart 17: The change in probability of default for credit extended in relation to certain products was estimated to increase between 450-600
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