In recent years, leaders around the world have expressed the need to move to a low-carbon economy. This transition can create opportunities for investment in green growth but could also pose risks to the financial system and its participants.
A framework to better understand climate transition risk
The shift away from fossil fuels as a key source of energy will challenge the business models of some firms. How quickly and orderly this transition occurs will affect whether and how investors revise their expectations for the future profits of these firms. This, in turn, could lead to an abrupt repricing of some financial assets. Financial entities—such as banks, pension funds and investment funds—currently involved in financing these firms could be impacted by such sudden reassessments. And the financial distress in one entity can spread to others given the interconnectedness in the financial system.
These issues are complex to analyze and model. Bank of Canada staff recently developed an analytical framework to map out the channels through which risks posed by the transition to a low-carbon economy could spread across entities and impact the broader financial system.
Direct and system-wide impacts of climate transition risk
The transition toward net-zero emissions will have varying effects on sectors in the economy. To understand the extent of changes to come, central banks have developed climate scenarios—a set of different possible futures that result from different paths of policy action taken to limit greenhouse gas emissions. Using such scenarios, financial entities can assess how the various types of risks they face—notably credit, market and liquidity risks—would likely evolve. These risks represent the direct impacts of the transition to a low-carbon economy on the financial system.
Meanwhile, a financial entity directly exposed to sectors impacted by the transition may take steps to protect its balance sheet. These actions could affect other entities, given the level of interconnectedness among participants in the financial system. For instance, many entities share a common exposure—they may be exposed to the same set of firms or industries affected by the transition. That common exposure could lead to additional selling pressure on market prices—a fire sale. Also, financial entities often hold shares in other financial entities, known as cross holdings, so the financial losses of one entity could cause losses for other entities. Finally, because financial entities often share the same business model (e.g., like banks do), markets may not discriminate enough between them and see them all in the same light.
Figure 1 shows how the direct and system-wide impacts may play out.
Figure 1: The interconnected nature of the financial system implies that the direct impacts of climate transition risk can cause system-wide impacts
Figure 1: The interconnected nature of the financial system implies that the direct impacts of climate transition risk can cause system-wide impacts
How this applies to the Canadian financial system
To understand the direct and system-wide impacts of climate transition risk in Canada, Bank staff conducted a study, assembling a large and novel dataset. This dataset contains information about:
- the direct exposure of Canadian financial entities to sectors that are likely to be impacted by the climate transition
- interconnections within and among types of entities in the financial system
Collaboration with provincial and federal regulators as well as financial market participants enabled the collection of these insightful data.
The study authors then applied a framework to these Canadian financial system data and mapped out the direct impacts of climate transition risk, finding the impacts to be generally modest. This partly reflects the limited exposure of Canadian financial entities to sectors of the economy that may be negatively impacted by the transition. Despite this limited exposure, the interconnections revealed in this study play a role in spreading the impacts of the climate transition risk to the overall financial system. In particular, common exposures, fire sales and cross-holding positions were found to be important transmission channels.
Lessons learned
This study significantly improves the Bank’s understanding of climate transition risk for the Canadian financial system. The data collected enable the better assessment of the links between financial entities and sectors of the economy that are likely to be impacted by the transition. The data also provide valuable insights into how different entities may respond to climate transition risk. For instance, some entities, such as investment funds, would likely spread and amplify climate transition shocks through the financial system while others, like pension funds, may help contain them.
This study also presented the opportunity for Bank staff to engage in discussions about climate transition risk with various Canadian financial system entities, notably pension funds. This collaboration shed light on long-term investors’ perspectives and how they assess and manage climate transition risks and opportunities.
This study also uncovered the many analytical challenges in assessing the effects of climate transition risk on the financial system. One such challenge is the lack of readily available data about direct exposures or interconnections within the financial system. This work highlights the need to establish standardized and systematic measurement and disclosure of exposures to climate transition risks. Another key challenge in evaluating climate transition risk is developing a simple yet comprehensive analytical framework to map out risks of transitioning to a low-carbon economy. This study is an important step toward this goal.