Ensuring the stability and efficiency of the financial system is a key part of our work at the Bank of Canada. This includes analyzing structural changes that affect the economy—like climate change. These changes could increase vulnerabilities to the financial system.
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Climate change poses significant risks to the financial system and the economy. These include disruptions from more frequent and severe extreme weather events as well as risks stemming from the transition to a low-carbon, net-zero economy.
Moving to a low-carbon economy will require work on a number of fronts—such as global policy action, technological innovation, more sustainable finance and large socio-economic changes. While these efforts to decarbonize economies create opportunities for investment and green growth, they also carry transition risks.
This report is about these transition risks. For the financial sector, mispricing of risks could expose financial institutions and investors to sudden and large losses. It could also delay investments needed to mitigate the impact of climate change.
In late 2020, the Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI) announced plans for an innovative pilot project with some of Canada’s key financial institutions. Its main goals were to:
- build the capability of authorities and financial institutions to conduct climate transition scenario analysis
- support the Canadian financial sector in improving its assessment and disclosure of climate-related risks
- help the financial sector to better understand its potential exposure to climate transition risks
The final report for this project was released on January 14, 2022.
Climate risks are challenging to assess accurately:
- They have long time horizons, and it is uncertain what future policy and socio-economic factors might look like.
- They are global and economy-wide in nature.
- They are complex, varying from region to region and sector to sector.
To overcome these challenges, the Bank and OSFI used scenario analysis—an innovative approach to gain a better understanding of transition risks. The scenarios in the pilot explore different possible future paths for both reducing both greenhouse gas emissions and mitigating their negative implications for the economy and financial system. They also include different assumptions for climate policy and the speed of technological change.
This approach builds on expertise the Bank has developed through staff research and our participation in the global Central Banks and Supervisors Network for Greening the Financial System. Most recently, we contributed to a number of publications to help improve global understanding of the impact of climate change on the financial system and world economy.
It’s important to note that the pilot scenarios are illustrative. They show potential stresses on the economy and the financial system. They are not predictions or forecasts, nor are they stress tests of individual financial institutions.
The scenarios also deliberately focus on transition risks rather than physical risks. These physical risks—and the steps we may take to mitigate or avoid them—could also have significant implications for the global and Canadian economies and the financial system. This is an area for future work.
Through this pilot, participants used climate transition scenarios to explore new methodologies to support climate-related financial risk assessments. The exercise highlighted the need to develop consistent ways to analyze and disclose climate risks. And it helped participants identify data gaps and develop a deeper understanding and awareness of the impacts of the climate transition risks on their portfolios.
The climate transition scenarios developed for the pilot showed that the economy as a whole will undergo significant structural changes as the world transitions to net zero. Substantial restructuring in many sectors may be required to meet climate targets.
For commodity-exporting countries like Canada, the transition also carries risks of significant macroeconomic impacts. These are driven mostly by declines in global prices of commodities brought by changes in global climate policy.
The pilot also highlighted the important role for innovation—for example, to scale up renewable energy technologies.
And it was clear through this exercise that, whatever path is chosen, delaying action heightens the risks to the financial sector and to the entire economy.
While the report does not make specific policy recommendations, it is an important contribution to the Bank’s overall efforts to better understand and model the economic and financial implications of climate change.
Financial institutions and financial authorities are in the early stages of building their capacity to assess risks tied to climate change. Overall, this exercise was an important first step in helping them improve their ability to analyze these financial risks. This will put them in a better position to measure their exposures to climate transition risks. It will also allow them to assess strategic business opportunities as we transition to a net-zero/low-carbon economy.
To assist the broader financial sector with these efforts, two supporting documents accompany the pilot project report. They describe in detail the financial risk assessment methodologies used in the pilot and the development and results of the climate transition scenarios. The Bank is also publishing the climate scenario data gathered for this exercise.