A prudential perspective on the risks of a changing climate, Opening remarks by Jeremy Rudin, Superintendent of Financial Institutions — 17th Annual Review of Insolvency Law (ARIL) Conference, Vancouver, British Columbia

Introduction

I want to start with a very perceptive observation in the final report of Canada’s Expert Panel on Sustainable Finance:

“It is not an exaggeration to say that our future hinges on how we respond to the challenge of climate change.” Footnote 1

Ultimately, all of us, including the financial sector, will have to adjust to a new reality. What that new reality will look like will depend on many complex issues and on much that is still uncertain.

When we, at OSFI, look at climate change, we look through the lens of the mandate given to us by Parliament as Canada’s prudential regulator and supervisor. That means that our focus is on the soundness of individual banks, insurers and private pension plans and on the stability of the financial system as a whole.

So when we look at climate change, we have to ask ourselves these questions:

  • How could climate change affect the financial soundness of individual institutions?
  • How could climate change affect the stability of the financial system?
  • How should we address these risks as the prudential regulator and supervisor?

Other parts of the federal government are tasked with considering other important questions such as:

  • What policies will best address Canada’s commitments to reduce greenhouse gas emissions?
  • What policies are needed to ensure that we adapt to the changes in the climate that will occur despite our efforts to reduce emissions?

At OSFI, by contrast, our assigned role is to ensure that Canadians will continue to enjoy financial stability as climate risks become a reality in Canada.

So, how to do that?

Like many financial sector regulators around the world, we use a simple yet comprehensive categorization of financial stability risks that can arise from climate change. There are three categories: physical risks, liability risks, and transition risks.

Physical Risk

Let’s start with the physical risks arising from the consequences of the changing climate. These include increased frequency and severity of wildfires, floods, and wind events and rising sea levels, among others.

When we look at the financial sector, we see that the most direct exposure is the potential increase in insurance claims for property damage that insurers will have to pay. Climate-related property damage has already risen in Canada: think of the extensive wildfires in the West and tornadoes in Ontario. Property claims can rise significantly even if there are few mega-events like the Fort McMurray wildfire. It is enough if the frequency of smaller events rises sharply.

Canadian insurers already have a great deal of experience with most of these perils. Yet neither the insurers nor we at OSFI can afford to be complacent about the possibility that a sudden increase in the frequency or severity of these events would catch one or more insurers unprepared.

Moreover, physical risks are not just an issue for property insurers. For example, it is possible that physical risks could directly impair the value of physical and financial assets owned by financial institutions and pension plans, such as commercial real estate and real estate investment funds. Physical risks could also indirectly impact the value of assets owned by financial institutions if the collateral posted by borrowers is exposed to physical risks.

So one of our tasks is to consider a range of severe but plausible scenarios for physical risks in Canada, and ensure that our institutions are prepared for them.

Liability Risk

Now let’s turn to liability risk. As lawyers, you will have noticed the recent surge in litigation related to climate change.

All of the defendants in those suits will have some liability insurance coverage, which means that their insurers are also exposed. The eventual cost of liability claims is often uncertain and cases can take decades to unfold.

If successful liability claims related to climate change are comparable to those arising from the mining and use of asbestos, the impact on the insurance industry will be significant, but manageable. However, we can’t rule out the possibility that the eventual bill for climate-related liability will be much larger.

So another one of our tasks is to determine that insurers are managing their exposures to liability claims so as to limit the potential impact to an amount that the insurer can afford to pay.

Transition Risk

Now let’s turn to what I expect will be the biggest risk: transition risk.

Transition risk arises from efforts to reduce greenhouse gas emissions rather than from the changing climate itself. These risks will result principally from the policies that governments have (or will) put in place to reduce emissions. It is also possible that transition risks will arise from changes in investor or consumer sentiment.

I find it useful to think of climate-related transition risk as coming in two “rounds.” You might think of them as happening in sequence.

The first round is the impact of the transition on those industries that will see their activities, and quite possibly their entire business models, strongly and directly disrupted. Industries such as fossil fuel production, electricity generation and transportation are likely to be on this list, and there will surely be others. The second round of transition risk arises as the decline in profits and employment in the disrupted industries ripples through the broader economy.

The impact on the economy need not be all negative. If we are going to transition to an economy characterized by low greenhouse gas emissions, we will create new economic opportunities at the same time that we disrupt existing ones. These new opportunities will also mean new opportunities for financial institutions. Indeed, we can hope that the overall impact on the economy will be mild, if not even positive.

But at present, we have very little reliable information about the second-round impact of the transition as so much depends on future policy decisions and yet-to-be-proven technologies. And we have to recognize that we won’t have much reliable evidence until we are well into the transition. So the prudent thing to do is to prepare for the possibility that the overall economic impact of the transition will be sharply negative, at least for some time.

As the prudential financial regulator, it’s long been our business to make sure that financial institutions are always prepared to continue functioning through a range of severe yet plausible economic scenarios. So we have already done considerable analysis about how a major economic disruption could impact the financial system. Now our task is to evaluate if those preparations are adequate to deal with the potential impact of climate change as well.

We need to ask ourselves:

Even if the financial system is prepared to navigate through a severe and prolonged recession, how might it still be unprepared for a transition to a low-greenhouse gas emission economy?

I think that answering that question will be our principal challenge in addressing the prudential implications of climate change in the years ahead.

Looking Ahead

In the thirty-plus years since OSFI was founded, we have developed extensive guidance for financial institutions about how to manage their risks. This guidance covers not only capital and liquidity requirements, but also risk management more broadly, corporate governance and disclosure requirements. Our existing guidance goes at least part of the way to addressing the physical, liability and transition risks to the financial system that arise from climate change.

But does it go far enough?

Fortunately, we’re not the only financial regulator and supervisor that is asking itself this question. We are working with our counterparts around the world to share ideas and experience in this area. For example, my OSFI colleagues participate actively in the Sustainable Insurance Forum, Footnote 2 which is a UN-sponsored grouping of financial regulators. We are also involved in the climate-related work that is being undertaken by the International Association of Insurance Supervisors. Footnote 3 And we benefit from the participation of our Bank of Canada colleagues in the climate-related work of the Bank for International Settlements Footnote 4 and the Network for the Greening of the Financial System. Footnote 5

As we always do when we are considering a significant new risk, we are seeking input from a variety of stakeholders. If we decide to update our guidance, we will publish it for consultation prior to its coming into force. These consultations will be a particularly important part of our work on climate-related risks.

We will have more to say about our work in this area as the year progresses.

Footnotes

Footnote 1

“Final Report of the Expert Panel on Sustainable Finance: Mobilizing Finance for Sustainable Growth”, Government of Canada, 2019, page 1 of PDF version. https://www.canada.ca/en/environment-climate-change/services/climate-change/expert-panel-sustainable-finance.html

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Footnote 2

Sustainable Insurance Forum https://www.sustainableinsuranceforum.org/

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Footnote 3

IAIS and SIF Issues Paper on Climate Change Risks to the Insurance Sector https://www.iaisweb.org/page/supervisory-material/issues-papers

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Footnote 4

The green swan: Central banking and financial stability in the age of climate change https://www.bis.org/publ/othp31.htm

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Footnote 5

Network for Greening the Financial System https://www.ngfs.net/en

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