Bank of Canada warns of costly risks if climate action is delayed

Delaying climate action leads to higher risks for Canada’s economy and financial sector, warns an analysis released 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 policies set at the end of 2019 to one that limits global warming to 1.5 C — the aspirational goal of the Paris Agreement. It was careful to say these scenarios are not forecasts or predictions, rather different possibilities to help identify where risks to the financial system might be through the clean energy transition.

In every scenario, significant changes to the Canadian economy are expected, and because the country has large carbon-intensive industries, like oil and gas, mining, and other heavy industries, the financial sector is entwined with these industries and faces increased risks as economies decarbonize.

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

The study looked at the 10 most emissions-intensive industries in the economy, representing 68 per cent of Canada’s greenhouse gas emissions. It found the six participating financial institutions had credit exposure totalling $239.3 billion. The banks accounted for roughly 55 per cent of those exposures and insurers accounted for the other 45 per cent. Credit exposure refers to what lenders would lose if the borrower defaulted on payment.

Exposure to the oil and gas industry was the highest at 29.9 per cent, with the electricity sector in second at 29.2 per cent given how much power is generated using fossil fuels. That means these energy-intensive sectors of the economy pose the highest risk to financial institutions during a transition off fossil fuels.

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

“Timely and clear climate policy direction and the correct pricing of risks, supported by climate-related financial disclosures, contribute strongly to mitigating these risks.”

The report focused solely on risks relating to the transition to a clean economy, meaning physical risks like flooding 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.

University of Waterloo research chair in sustainable finance Olaf Weber told Canada’s National Observer that these types of scenario analyses are relatively new for the financial sector, but because there are too many unknowns about what the transition will look like, financial institutions now recognize the need to plan for a variety of possibilities.

“Let's say we want to meet (climate) goals,” he said. “Then 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 however we do that, there will be consequences on 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, meaning energy policies that jeopardize fossil fuel profitability threaten the banks’ bottom line. But, as the Bank of Canada and OSFI report says, “delayed action leads to a sharper transition” and sharper transitions mean greater risks.

Based on participant feedback, high among the report’s findings are a need for more climate risk data and standardized reporting to guide investment decisions.

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

“On the one hand, they're right — we don't have any standardized mandatory reporting on climate risks or GHG emissions. But on the other hand, they could put more pressure on their clients (to) deliver that,” he said.

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

Weber applauded the report’s effort to jumpstart a broader discussion about managing financial risks through a green transition, particularly for a country as exposed to the risks as Canada is, but said he’d like to see action ramped up.

“We're starting now with assessing the risk, and maybe the next step will be coming up with standardized indicators,” he said.

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

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

The initiatives include publishing a guidance document for climate risk management, studying data gaps and building on the scenario analysis published Friday with further work. The further work includes studying capital and liquidity to manage climate risks, looking at climate-related financial disclosures, working “domestically and internationally” with other stakeholders “within and outside the financial industry” and growing the agency’s own capability through its climate risk hub.