Canada’s Office of the Superintendent of Financial Institutions (OSFI) has announced that it will launch a pilot project to build out climate-change related scenario analysis and predict how climate-change related risks could affect the future of financial services.
Coronavirus and climate change – not dissimilar events
In his remarks for OSFI’s Global Risk Institute (GRI), Superintendent Jeremy Rudin compared the coronavirus pandemic to climate change in terms of its unpredictability and effect on the financial industry. He noted that many of the challenges posed and lessons learnt throughout the coronavirus pandemic can help chart the path on climate risk, “our experience in the pandemic is highly instructive about how climate-related risks will touch the financial sector” he said.
Essentially, climate change and the pandemic are comparable insofar as they are both major external shocks that will eventually have significant impacts on the financial sector. Even when an external shock is foreseeable, such as climate change, there are aspects of that shock that will remain outside the realm of previous experience and therefore be unforeseeable.
There was, and remains, a high degree of uncertainty about the pandemic, in the same way that there will be a high degree of uncertainty about how climate-related risks will affect the financial sector. The key, Rudin commented, will be ensuring that the financial sector is prepared for myriad severe but plausible scenarios; to predict the unpredictable as best as possible.
3 key risks to the financial system
OSFI believes that the risks presented by climate change to the financial sector can be broadly categorised into three groups:
1. Physical risk
The impact caused by direct damage to physical assets from climate change events such as extreme weather and rising sea levels. Financial impact then arises from higher insurance claims, reduction in the value of investments or in the reduced value of loan collateral.
2. Liability risk
The impact on an institution that must deal with the consequences of third-party claims for damages caused by climate change, for example property or casualty insurers.
3. Transition risk
The impact of the transition to a low-greenhouse-gas emission economy, including shifting investor and consumer preferences.
Change is inevitable – from coronavirus to the climate
Rudin suggests that the shifting attitudes and varying public responses to the pandemic so far – from mask wearing to the opening of schools – allows us to better understand the challenges of managing transition risk. “Changes were and are inevitable”, he added.
Ultimately, risk management has caused people to learn by experience – which policies are most effective? Which new technologies were proven or disproven? How is public sentiment changing? The questions were all posed during the coronavirus pandemic and will continue to be asked as firms and society grapple with climate change. The transition to dramatically lower greenhouse gas emissions, as Rudin points out, is also something beyond our previous experience. As such:
“Climate change policy will evolve over time, and it will evolve in ways that are difficult if not impossible to predict.”
Preparation through scenario analysis – a pilot project in 2021
OSFI notes that it has a unique role to play – to ensure that Canadians continue to enjoy financial stability while climate-related risks manifest. In order to do so it must ensure that the financial sector is able to manage in a wide range of transition scenarios.
In light of this, OSFI will be working with the Bank of Canada, as well as a group of banks and insurers, to create a scenario analysis of the transition. This pilot project will aim to build climate-scenario analysis knowledge and increase the understanding of the financial sector’s exposure to climate-change related risks. The project will begin in 2021 and aim to publish a report by the end of the year.
OSFI’s commitment to climate change falls into line with messaging from global financial regulators. Far from distracting or detracting from the increasing risks of climate change, the coronavirus pandemic seems to have sharpened financial services’ focus on tackling it.
It is true, of course, that much as the pandemic was unpredictable, the future of finance will remain unpredictable when faced with climate risks such as devalued assets, stale commodities and shifting consumer attitude. It perhaps makes sense then that financial services are looking to learn from the wavering predictability of coronavirus.
As Rudin points out, the framework for financial policies will continue to evolve as “a policy framework that does not evolve is bound to be a failure”. As such, financial institutions will need to be flexible and agile in both their approaches and the systems they have in place to manage the policies and controls. Embracing the inevitable change could lead to growth and opportunity, if managed well.