The Bank of Canada is warning prices for debt and equity tied to carbon-intensive industries fail to adequately factor in the risks of climate change, leaving investors exposed to the potential of sudden losses in value.
Such financial instruments are susceptible to the physical effects of climate change, such as more intense storms and floods, as well disruption from the transition to cleaner forms of energy, the central bank said in its annual Financial System Review, released on Thursday.
This “mispricing” – one of several economic vulnerabilities the bank highlighted in its report – could delay the massive investments in clean technologies needed for Canada to achieve its carbon emissions reduction targets, it said. The country is a signatory to the Paris Agreement, which is aimed at limiting the average rise in global temperatures to 1.5 degrees.
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“The potential impact of climate risks is generally underappreciated, and they are not well priced,” Bank of Canada Governor Tiff Macklem said. “That means the transition to a low-carbon economy could leave some investors and financial institutions exposed to large losses in the future.”
The bank did not raise the spectre of stranded assets – those whose commercial usefulness would end in the transition to more climate-friendly technology – though many analysts have pointed to that prospect among many long-term risks.
The Bank of Canada’s statement comes amid a global push to align financial systems with what’s needed to deal with the risks of climate change to economies. Those are already transforming many industries such as energy and transportation, and causing dislocation in labour markets. But the bank also brought another aspect home to Canadians, highlighting the risks of climate-related disasters on areas of the country with high levels of household debt.
The bank pointed out that there is strong momentum among governments and investors to deal with climate change, as countries prepare to meet in Glasgow, Scotland, for the next United Nations climate conference in November. Canada last month toughened its commitment to reduce greenhouse gas emissions, setting a new target to cut by 45 per cent from 2005 levels by 2030.
Underestimating climate risk “is a very legitimate concern regarding asset prices, and one that we frequently hear expressed by financial institutions in our conversations with them,” said Sean Cleary, executive director of the Institute for Sustainable Finance at Queen’s University’s Smith School of Business.
Prof. Cleary pointed to the bank’s assertion that a big problem facing investors is a “data gap” in climate-related information that can only be fixed with standardized disclosure systems adopted on a global scale.
The federal government has joined major investors in promoting use of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD). In its April budget, the government said it plans to “engage” with the provinces and territories to make TCFD part of regular disclosure practices. It is also mandating use of TFCD standards by Crown corporations, though there is no regulation making adoption in the private sector mandatory.
In its review, the bank said it was concerned about the twin risks of high household debt and climate change. Natural disasters are becoming more frequent and can cause severe financial hardship to households, it said. For example, the Fort McMurray, Alta., wildfires in 2016 caused a big increase in homeowners falling behind on mortgage payments.
Large parts of British Columbia and Ontario have tight correlations of those risks. “These different combinations of disaster exposure and financial vulnerabilities could have implications for how natural disasters affect the economy and the financial system as well as for the appropriate policy responses,” the bank said.
Meanwhile, Mr. Macklem said federal green bonds – which are used to finance projects with clear environmental benefits – could become a benchmark for pricing such securities issued by others, such as provinces. Ottawa has said it intends to issue $5-billion worth of the bonds to finance clean energy infrastructure and technology.
The securities should attract strong investor interest, he told reporters, and the central bank may even purchase them as part of its quantitative easing program, in which it buys federal bonds to help keep interest rates down.
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Jeffrey Jones