By Michael Tencer, FCIA
Climate-related financial risks have emerged as some of the most important topics among risk professionals. While plenty of material has been produced to provide essential learning about the sources and definitions of climate-related risk, a practical climate-risk exercise focused on the Canadian financial system was notably absent.
The 2021 Bank of Canada (BoC)/Office of the Superintendent of Financial Institutions (OSFI) climate scenario analysis pilot filled that void and took a big step forward in assessing systemic risk for Canadian financial institutions.
One of the main objectives of the pilot was to gain insight on the exposure to risk from transitioning to a low-carbon economy, while also building the authorities’ and participating financial institutions’ climate scenario analysis capabilities.
This article highlights the pilot project’s approach to scenario analysis, a tried-and-true risk assessment approach familiar to actuaries, and summarizes key findings. For a more in-depth review of the project, refer to the BoC’s full report and supplemental technical papers, which were released in January 2022.
The pilot asked participants to consider four scenarios with respect to a transition to a low-carbon economy on a portion of their fixed-income and equity asset portfolio. The 10 highest-emitting sectors were in scope while all other sectors, liabilities, and physical risk were out of scope.
The four scenarios were:
- Baseline, where there is no change to global climate policies.
- Below 2°C immediate, where policy action to limit average global warming occurs immediately.
- Below 2°C delayed, where policy action to limit average global warming is delayed.
- Net-zero 2050, where more ambitious policy actions are implemented immediately.
Baseline and both below 2°C scenarios assume a slow pace of technological advancement, preventing industries from taking advantage of technologies that are not yet commercially available. While the net-zero 2050 scenario assumes a faster pace of technological change, incorporating the use of game-changing carbon-capture and -storage capabilities.
The BoC built on the scenarios released by the Network for Greening the Financial System and partnered with the Massachusetts Institute of Technology (MIT) to develop its own set of scenario data that reflects the sector and geographical granularity most relevant to Canadian financial institutions.
The dataset provided by the BoC is very detailed and comprises several climate-related economic variables projected out to 2050. Some examples of the data variables are greenhouse-gas emissions, energy demand, energy prices, vehicle miles travelled, and share of electric vehicles.
To determine the credit risk impact, the pilot participants selected five representative borrowers in their portfolios from a sub-sector; sub-sectors were methodically determined by the BoC to group companies with similar risk exposure characteristics.
The participants were then tasked with determining the impact to the probability of default (PD) and associated change in credit rating for each selected borrower under each scenario. This bottom-up calculation of impact to PD and credit rating made use of top-down sub-sector financial impacts calculated by the BoC. The credit risk result also made use of expert judgment from the participating firms. The BoC aggregated the sample data from each participant and, using a variety of models, extrapolated the credit risk to the national portfolio.
To assess the market risk on equity assets, a top-down approach was used, which did not require input from the participating institutions. The BoC employed a discounted dividend model to determine the impact on equity valuations for each sector that was in scope.
The pilot achieved its objective of providing financial authorities and participating financial institutions a foundational experience in using climate scenario analysis to identify and assess climate-related transition risk. While a quantitative conclusion was not provided, the authorities and participants increased their understanding of the Canadian financial system’s potential exposure to risks associated with a transition to a low-carbon economy.
In addition, the pilot project provided a valuable opportunity for peer collaboration and idea sharing among firms.
Some valuable lessons were learned along the way. The participants noted that the exercise was more difficult and time-consuming than initially anticipated. The BoC also observed considerable variability of results from the participating firms. In some cases, the same data and assumptions applied by the participants to the same borrower yielded very different credit risk impacts. Some of the challenges in generating consistent credit risk conclusions, as noted in the report, were:
- classifying a borrower with a diversified business,
- different internal financial models among the participants, and
- varying approaches to applying expert judgment.
This pilot project demonstrates that the BoC and OSFI are committed to improving the financial system’s climate-related risk assessment capabilities. The technical modelling work completed by the BoC with their partners at MIT provided a strong foundation for future stress-testing objectives. Financial institutions now have a valuable and detailed dataset to use as they embark on setting internal climate-risk strategies.
The lessons learned provided the authorities with areas of focus for future iterations of climate-related risk scenario analysis. The BoC refers to including physical risks and other financial institutions, and to expanding the scope of assets as areas for future considerations. Developing an objective and repeatable methodology for climate risk assessment is also highlighted as an area to address in future work.
On April 27, representatives from the BoC and OSFI will join me for a CIA webcast moderated by Karen Lockridge, FCIA, to share more insight about this project. Please join us for an opportunity to have your questions answered and learn more.
Michael Tencer, FCIA, is the Director of Capital Stress Testing at Manulife and a member of the CIA’s Climate Change and Sustainability Committee. Michael has led several climate change stress tests over the past few years to gain insight into the impact of climate-related risks on Manulife’s investment portfolios and regulatory capital.
This article reflects the opinion of the author and does not represent an official statement of the CIA.