A complex climate: Charting a path for an uncertain future

Remarks for the Superintendent of Financial Institutions to the Global Risk Institute

December 11, 2020

Introduction

Thank you Sonia, and thanks also to the Global Risk Institute, for having me with you today.

I know that GRI is playing an important role in helping to advance the financial sector’s understanding of climate-related risks, so I am glad to be able to work with you on this very significant issue.

At OSFI, we also have an important role to play. Our assigned role is to ensure that Canadians will continue to enjoy financial stability as climate-related risks become a reality in Canada. This is an essential role, and we are the only arm of the Government of Canada that is equipped to do this. So we are very focused on that task.

Drawing on lessons from the pandemic to help chart the path on climate risk

While I have promised you a talk about climate-related risks, I am going to start by talking about the pandemic. Why would I do that? Because I think that our experience in the pandemic is highly instructive about how climate-related risks will touch the financial sector.

In my view, there are two important lessons that we can take from our experience so far in the pandemic.

First, any major external shock will inevitably find its way into the financial system. Just as the pandemic had a significant impact on the financial sector, so will climate change.

Second, even when the arrival of a major external shock becomes foreseeable, there will be important aspects of that shock that are anything but foreseeable, if the shock is outside the realm of our previous experience.

By mid-March, for example, we were all certain that the pandemic would arrive in Canada. Yet there was (and there remains) a high degree of uncertainty about how the public health situation would evolve, how public policy would respond to that public health situation, and how public opinion would respond in turn.

The same types of uncertainty will characterize climate change.

As a result, just as there was (and there remains) a high degree of uncertainty about how the pandemic will affect the financial sector, there is (and there will be) a high degree of uncertainty about how climate-related risks will affect the financial sector.

Fortunately, ensuring that the financial sector is prepared for a wide range of severe but plausible scenarios is our stock in trade at OSFI. So I think that we are well-positioned to play our role effectively.

I will come back to these points of comparison between the pandemic and climate change as I sketch out the work on climate-related risks that we are doing at OSFI.

A changing climate - What we know and what we can we anticipate

Let us start by laying out what we already know.

We know that there is clear evidence that Canada’s climate is warming and that this irreversible change is in large part due to human influence on greenhouse gas emissions.

We also know that the changing climate is leading to more extreme climate-related events in Canada and around the world.

And we know that by endorsing the Paris Agreement, Canada has committed to strengthening its policy efforts to help limit the global temperature rise this century, foster climate resilience, and transition to a low-greenhouse gas economy.Footnote 1

Risks to the financial system fall within three key areas

Now let us turn to what all of this could mean for the financial sector.

Financial regulators around the world like to group climate-related risks into three distinct buckets: physical risks, liability risks, and transition risks. I spoke at some length about each of these risk areas in remarks I made earlier this year, so I will limit myself to a quick overview today.

Physical risk is the impact to institutions from direct damage to physical assets from extreme climate events, rising sea levels, catastrophic weather events and the like. For banks, insurers and pension plans the financial impact arises from higher property insurance claims, from reductions in the value of investments, or from reduced value of loan collateral. Similar to what we have experienced during the pandemic, we can be certain that climate-related physical risks will manifest as financial risks. We are much less certain, however, about how and when this will occur.

Liability risk is the impact on an institution that bears the consequences of third-party claims for damages caused by climate change. This risk arises particularly for property and casualty insurers. Similar to what we have experienced during the pandemic with business interruption insurance claims, this risk will not be readily quantifiable until a variety of legal actions make their protracted way through the courts.

Finally, transition risk refers to the impacts of the transition to a low-greenhouse-gas emission economy. These risks arise largely from the policy responses that Canadian and foreign governments will implement to induce the needed transition to lower greenhouse gas emissions. Changing investor and consumer preferences will probably also play an important role.

Climate policy evolution and the need to prepare for a range of transition scenarios

We can get a better appreciation for the challenge of managing transition risk by reviewing the policy and public responses to the pandemic so far.

Of course, you know that public health measures for combatting the pandemic have changed in important ways over the past nine months.

We have gone from policy that encouraged mask use only for health care providers, to policy that encouraged mask use as a way to protect others, to policy that encouraged mask use as a way to protect yourself and others.

We have gone from an emphasis on keeping schools closed to an emphasis on keeping schools open.

And we have gone from initially high levels of public co-operation with these policies to much more variable degrees of compliance

These shifts have been frustrating for many. Clearly they have made it difficult for people and businesses to make plans. But, we have to face the facts: these sorts of changes were and are inevitable.

Faced with a pandemic that was beyond our previous experience, policy choices have necessarily evolved. We needed to learn by experience which policies were most effective. We needed to see which new technologies were proven or disproven. And we needed to observe how public sentiment changed. In a situation like this the policy framework will necessarily evolve, because a policy framework that does not evolve is bound to be a failure.

Clearly, the transition to dramatically lower greenhouse gas emissions is also something beyond our previous experience. So climate change policy will also evolve over time, and it will evolve in ways that are difficult if not impossible to predict. If policy does not evolve in this way, we will not achieve the dramatic reduction in greenhouse gas emissions that we seek.

Building a clearer picture of the future through scenario analysis

What does this mean for OSFI? It means that to fulfill our unique role of ensuring that Canadians continue to enjoy financial stability while climate-related risks manifest, we will need to ensure that the financial sector is prepared to manage through a wide range of transition scenarios.

This is why we are very pleased to be working with the Bank of Canada and some of our banks and insurers on scenario analysis of the transition. We cannot afford to be paralysed by the uncertainty inherent in the problem. Rather, we are turning to scenario analysis to help enhance our thinking and that of the industry. This work will provide some concrete insights into the risks to the financial system from the transition to a low-greenhouse gas economy, as well as the opportunities that this transition could present.

A small group of companies from the banking and insurance sectors are participating in this pilot project with us.

Through this project we will:

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

The first step of the pilot project is to develop a Canada-relevant set of transition scenarios, and financial risk assessment methods and metrics. We are targeting to complete this step in the first half of 2021.

Next, using these scenarios, participants will explore the potential risk exposures on their balance sheets. We are aiming to complete this step in the second half of 2021.

Finally, along with the Bank of Canada, we plan to publish a report near the end of 2021, sharing details on the specific scenarios, methods, assumptions and key sensitivities.

We look forward to sharing our insights with you when we reach that point. We also intend to draw on those insights to inform OSFI’s work more broadly with financial market participants in the area of climate risk.

In the meantime, we are busy with other aspects of our work to help to prepare the financial sector for climate-related risks.

Increasing stakeholder engagement in designing the prudential path forward

The institutions we supervise already know that we expect them to take a forward-looking approach to managing all of their material risks. This includes understanding how those risks can affect their business and investment strategies, risk profile and capital management. And we look for institutions to show us that they are managing those risks effectively.

Our existing guidance and supervisory practices are largely principles based, so they already go at least part of the way to addressing the physical, liability and transition risks to the financial system that arise from climate change.

That said, we are asking ourselves if they go far enough. And soon, we will be asking you the same question.

We plan to publish a paper on the prudential approach to climate-related risks in early January. This will be a discussion paper, rather than a specific set of proposals. And it is about an important environmental issue. So it will be, in two senses, a ‘green paper’.

We have chosen the discussion paper format so that we can engage in dialogue with our regulated entities and with other interested stakeholders about:

  • how climate-related risks can affect the safety and soundness of financial institutions;
  • how institutions define, identify, measure and build resilience to climate-related risks; and
  • the role that OSFI can and should play to facilitate their preparedness and resilience to these risks.

The paper is going to outline our current thinking about various areas of climate-related risk and ask a series of challenging questions about the ways that banks, insurers and pension plans can better prepare for, and build financial resilience to, these risks.

We are also looking for feedback on current and potential practices related to:  risk appetite and strategy development, risk governance, risk management, disclosure, among other topics.

OSFI is charting the prudential path on climate-related risks, and thinking through how these risks could challenge the safety and soundness of Canada’s financial institutions, private pension plans and the broader financial system.

Your feedback will help to inform our analysis of the need for future guidance and supervisory responses to climate-related risks.

So we very much look forward to receiving your views.

Conclusion

I will conclude by returning to the pandemic for a moment. A number of people have asked me: “Jeremy, didn't you have a pandemic plan?” We did, and the financial institutions had pandemic plans as well. We just did not have a plan for this particular pandemic. At OSFI, for example, we had stocked up on masks and gloves because we had a plan for a pandemic where everyone continued to work in their usual way while taking extra precautions to avoid catching or spreading the disease. That is a type of pandemic, but it is not the pandemic that we are now living through.

Fortunately, the Canadian financial sector had the capital resilience, the liquidity resilience and the operational resilience to navigate the current pandemic, aided by very strong support from our fiscal and monetary authorities. We have seen that the financial sector was prepared for a sufficiently wide range of severe but plausible scenarios, that it was ready for the current disruption even though we did not foresee all the details.

The same needs to be true of our preparations for climate-related risks. We know that the climate will continue to change. Yet that does not tell us which climate-related events will have significant impacts on the financial sector nor when those events will occur.

We know that Canada is committed to a dramatic reduction in greenhouse gas emissions. Yet there are still many different ways for that transition to unfold, and many different time paths that it could take.

Just as we now see the value of preparing for more than one pandemic scenario, we will need to prepare for a wide range of climate-related risk scenarios as well. I am confident that the Canadian financial sector will be up to that task. With OSFI’s help, of course.

As I noted earlier, we will have a number of questions for you in our January discussion paper, so it is only fair to let you pose some questions to me, now.

Footnotes

Footnote 1

Environment and Climate Change Canada (2016): The Paris Agreement

Return to footnote 1