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Eastbound morning rush hour traffic on the Gardiner Expressway into Toronto on Oct. 10, 2017.Fred Lum/The Globe and Mail

Canada’s central bank and financial regulator are teaming up with a group of banks and insurance companies to gauge how risks related to climate change and a transition toward a low carbon economy could have an effect on the financial system.

The Bank of Canada and Office of the Superintendent of Financial Institutions announced a pilot project on Monday that will look at various “climate change scenarios" and assess how they could affect bank and insurance company balance sheets.

Regulators and central banks around the world are racing to develop better tools to quantify long-term risks to financial system stability posed by climate change. At the same time, financial institutions are looking for better ways to assess how their large and diffuse portfolios will be affected by everything from higher carbon taxes to increased flooding.

“Everyone, including the financial sector, will have to adjust to the new reality of climate change. The shape of that new reality will depend on many complex issues and on much that remains uncertain,” OSFI superintendent Jeremy Rudin said in a statement. “This pilot project will allow us to refine our focus on the prudential aspects of climate change.”

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The project will focus on “transition risks” related to climate change. This means analyzing policy shifts around things such as carbon taxes, technological change and shifting consumer and investor preferences. The study will not focus on physical risks, such as an increase in heat waves and forest fires.

Two banks (Royal Bank of Canada and Toronto-Dominion Bank) and four insurance companies (Intact Financial Corp., Manulife Financial Corp., Sun Life Financial Inc. and Co-operators Group Ltd.) are taking part in the initiative. This will allow OSFI and the Bank of Canada to apply their models to the actual balance sheets of major Canadian financial institutions.

The goal, however, is not an “assessment of individual financial institutions' exposure to climate-related risks or the broader financial sector’s resilience to transition risks," OSFI and the Bank of Canada said in a news release. Rather, the idea is to provide the regulator and the central bank with better tools for future analysis.

The “scenario analysis” approach differs from most financial modelling done by OSFI and the Bank of Canada. It will look much further into the future and deal with more hypotheticals.

“To be the most useful, these scenarios should be extreme yet plausible. This will give a sense of the full range of possible risks," a Bank of Canada researcher explained in a climate change scenario analysis report published earlier this year.

The Bank of Canada has been conducting scenario analysis research as part of an international effort by central bankers called the Network for Greening the Financial System. Earlier this year, Bank of Canada researchers looked at how gross domestic product would be affected under four different scenarios, in which governments responded to climate change in more or less aggressive ways.

“The results suggest that while transition risks can be avoided through inaction, this comes at significant economic costs through higher physical damages and risks. Finally, action that comes late must be more abrupt to keep temperature increases in check, raising transition risk,” wrote Erik Ens and Craig Johnston, the report’s authors.

“Transition risks increase with shorter transition periods ... because agents have less time to adapt, and technological offsets to the decline in fossil-fuel production (e.g., cheaper renewable sources of energy) have less time to develop," they wrote.

OSFI and the Bank of Canada expect to publish a report on the pilot project by late 2021.

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