Canada’s long-term economic growth and the stability of its financial system could be put at risk if the country delays implementing policies to deal with the transition to a low-carbon world, the central bank and the banking regulator say in a report analyzing a range of possible climate scenarios.
The Bank of Canada and the Office of the Superintendent of Financial Institutions examined the balance sheets of Royal Bank of Canada RY-T, Toronto Dominion Bank TD-T and four large insurance companies to see how the institutions would be impacted by various policies aimed at achieving net-zero emissions.
The goal of the report, the product of a pilot program being run by the two agencies, is to quantify clean energy transition risks – including those related to government policies, like carbon prices, and those related to changing market dynamics. The report does not look at physical risks tied to extreme weather events and a warming climate.
“All scenarios showed that as we globally transition to net-zero, some sectors will be significantly impacted and the economy as a whole will undergo significant structural changes. This transition will prove more challenging in commodity-exporting countries just like Canada,” Toni Gravelle, deputy governor of the Bank of Canada, told reporters. “The pilot also showed that delayed action increases the risks to the financial sector and to the entire economy.”
The research is among several initiatives across the country aimed at gauging financial and economic effects from climate change, as the world moves closer to a 2050 target for reducing emissions in the hopes of keeping global temperature rise between 1.5 and 2 C above preindustrial levels.
The pace of change is crucial to financial stability. The central bank and OSFI looked at four different scenarios. In some of them, policy makers move with great urgency to meet carbon reduction targets, and in others they move more slowly. The report warns that a late and abrupt shift in policy could lead to assets suddenly losing value and a “rapid repricing of climate-related risks.” This could take a toll on the balance sheets of financial institutions that finance carbon-intensive industries.
Canada is highly exposed to changing energy demand because of the size and importance of its oil and gas industry. All four scenarios point to a “material” decline in GDP over the transition period, largely as a result of less global demand for Canadian oil.
The report argues that the coming green energy transition will slow the pace of inflation over the long term – a conclusion that could have implications for monetary policy. Mr. Gravelle said structural forces would likely keep interest rates low and accommodative.
“For Canada and many economies, relative to baseline, there’s a slower growth path, and that slower growth path means there’s less inflation,” he said.
OSFI and the Bank of Canada looked at the six financial institutions’ exposure to the 10 most carbon-intensive sectors, including agriculture, fossil fuels, electricity and transport, which together account for 68 per cent of Canada’s emissions.
TD and RBC examined their wholesale loan portfolio. The insurance companies – Co-operators Group CCS-PR-C-T, Intact Financial IFC-T, Manulife Financial MFC-T and Sun Life Financial SLF-T – looked at their bond and corporate loans portfolios, as well as market risk to their equity holdings. The total credit exposure across the six companies was $239.3-billion. That amounted to 5 per cent of the banks’ balance sheets, and 15 per cent of the insurers’ balance sheets.
OSFI said early this week that it may have to raise financial institutions’ capital requirements in the coming years as a buffer to offset climate-related risks. The scenario analysis, and the data, methods and standards it required, will help inform any such moves over the next decade, said Ben Gully, assistant superintendent at OSFI, during a news conference. The key is improving risk management, he added.
“Given the maturity of those practices and the data, we’ll have an evidence base upon which to evaluate capital. And it’s at that point we can have a meaningful discussion of how much and in what form capital requirements serve,” Mr. Gully said.
The report estimates that oil and gas companies could suffer an 80-per-cent or greater decline in income by 2050, across multiple scenarios. Meanwhile, their probability of default on debt is projected to increase by around 200 per cent.
The two sectors seen as benefitting most from the transition are commercial transport and electricity. There are, nonetheless, divergences within these sectors. For example, air and water transportation are hard to decarbonize, while trains are easy to electrify, the report said.
The report contains important caveats. It puts little weight on early-stage technologies, such as carbon capture and storage, which could reduce the burden of carbon taxes. It also does not attempt to quantify potential economic gains from the introduction of new technologies or an overhaul of the energy system.
The report was released as regulators around the world move toward formalizing and standardizing climate-related financial disclosure to help gauge risks. Canadian Securities Administrators, for example, has proposed making such disclosure mandatory for publicly traded companies. Controversially, CSA is considering freeing companies from having to conduct scenario analysis as part of its proposed rules.
Mr. Gravelle said the Bank of Canada and OSFI work can be used as a guide for companies in a range of industries to begin their own analyses.
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