Managing climate risk will be rewarded with better economic outcomes

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Sonia Baxendale is the chief executive officer of the Global Risk Institute in Financial Services

A recent report from Moody’s suggested that Canada could be a “climate winner” with its GDP increasing by up to 0.3 per cent through initiatives such as greater agricultural output. This upbeat outlook is in sharp contrast to what Western Canada experienced this summer with forest fires, record temperatures and withering crops.

And last week, the United Nations Intergovernmental Panel on Climate Change (IPCC) issued its report that clearly points to a narrowing of the path that can be taken to stabilize the planet’s climate.

What these reports suggest is that countries that more effectively manage climate risk will be rewarded with better economic outcomes. And, as our nation proved during the global financial crisis a decade ago, we are pretty good at managing risk when industry, academia and government work together.

As a nation, we have an obligation to our stakeholders, shareholders and future generations to drive the innovation needed to create a sustainable low-carbon economy today – not in the distant future. Canadian financial institutions provide capital and leverage to the country’s societal and economic activity, and must play their part in managing and mitigating climate risk and accelerating low-carbon opportunities. To do so requires a fundamental shift in their business model for assessing risk when deploying capital.

The Global Risk Institute for Financial Services recently released a paper that looks at five top takeaways from the IPCC report that will affect Canada’s financial services sector.

1. Canada is in the crosshairs, and the world agrees. An increase in low-carbon ambition from other countries will have major ramifications for Canada’s energy and resource economy. For example, oil-producing economies are facing pressure to eliminate fossil-fuel subsidies and increase the number of sectors paying a carbon tax in order to speed the diversification of the energy sector. The consequent effect on the bottom line is that borrowers in the fossil-fuel sector or with high emission footprints will find it difficult to get credit. At the same time, lenders and institutional investors will be forced by their own credit risk models, as opposed to just public opinion, to reduce credit to high-carbon businesses.

2. Clearer, data-driven future scenarios are now possible. Recent scientific breakthroughs now provide better data to analyze climate-risk scenarios. For those who allocate capital and lend, a clearer picture of what will happen if emissions are not cut to adequate levels can improve the ability to accurately price related risk. On the insurance side this could result in increased premiums or restricted access to insurance or reinsurance. Risk-based capital allocation can be better defined and regulators are poised to respond. For example, the EU financial markets regulator is already considering additional capital requirements in response to climate risk.

3. Liability risk set to rise as human influence on the climate is now “unequivocal.” Scientists are now able to link specific weather events to human-made climate change, something that had evaded them over the past decades. As a result, firms will reassess contracts, which may have climate-related liability exposure. This field could follow a similar trajectory as the evolution of liability in the tobacco industry – more legal suits for exposed industries, thereby having a knock-on effect for credit and market risk, and possibly direct legal risk for financial firms if they have financed known polluting industries that can be linked to damaging weather events.

4. Doubling down on transition finance and the move to a low-carbon economy. Leading financial institutions globally have signed on to the Glasgow Financial Alliance for Net Zero (GFANZ). The GFANZ recognizes that it will take a transition of the entire economy to achieve net-zero emissions and that every company, bank, insurer and investor will have to adjust their business models, develop credible plans for the transition and implement them. The report provides a clearer picture of the benefits of cutting emissions, such as reduced floods, fires, droughts, and the numerous upsides for capitalizing on sustainable finance.

5. Investment in the one entity that can soften the blow: Mother Earth. The IPCC study presents a clearer picture of climatic processes that are now irreversible and worsening in an accelerating positive feedback loop. These insights will drive increased demand for financing of adaptation, resilience, and nature-based solutions to protect or change existing at-risk infrastructure. Retrofitting, for example, is expected to become a greater proportion of the sustainable finance market. Insurers, lenders and investors will better understand the longer-term outlook for physical assets and infrastructure that can support better asset allocation, underwriting and pricing.

Canada was a global leader during the financial crisis a decade ago because of our ability to manage financial risk better than most countries. Now is the time for Canada to come together, do what we must for future generations, and punch above our weight on climate.

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