Kevin Quinlan is senior adviser at Mantle314, a climate change consultancy.
Canadians are used to hearing about mortgage stress testing, but it’s time Canada started looking at climate stress testing.
There is growing uncertainty about the pace and scale of the transition away from fossil fuels. Although there are tremendous business opportunities in moving to a low-carbon economy, we should not be lulled into thinking it will be smooth and orderly.
The Bank of Canada has named climate change as one of six vulnerabilities in the country’s financial system, warning that Canadian companies are not adequately disclosing how they are being affected. This makes it difficult for regulators and investors to properly assess risk, leaving us vulnerable to shocks that could destabilize the system.
Other countries with economies less carbon-intensive than Canada’s are ahead of us. The Bank of England is requiring insurers to simulate specific climate scenarios on their liabilities and investments, including one in which oil equities drop more than 40 per cent.
The Netherlands recently ran an energy transition stress test on its banks, insurers and pension funds. The central bank looked at four “severe but plausible” transition scenarios in which sudden technology, policy and confidence shocks take place, as well as a “double shock” scenario – a worst-case option in which multiple scenarios converge at one time.
The results from the Dutch stress tests highlighted how financial institutions could reduce risk and avoid unnecessary losses. It also identified areas that policy makers could address to enhance resilience – information that would be highly valuable in a Canadian context.
New information continues to emerge that throws into question the assumptions many Canadian companies and policy makers operate on.
DNV GL, an energy consultancy out of Norway, is now forecasting that global demand for oil will peak in 2022, owing to a surge in electric-vehicle adoption and a bearish outlook on petrochemicals. The demand for natural gas could surpass global oil demand by 2026.
In August, BNP Paribas released research comparing the energy return on capital invested in oil and renewables where the energy is being used for cars. They calculated that the long-term break-even oil price for gasoline to remain competitive with renewable energy as a source of mobility is $9 a barrel.
Is anyone asking what these scenarios could mean for Canada’s economy, which is built on the assumption that global oil demand will grow for decades to come?
The Bank of Canada is well positioned to do this work. It has committed to a multiyear research plan on climate-related risks and recently joined the Network for Greening the Financial System, a global alliance of central banks that shares best practices on how to identify and manage climate risk.
The bank could run scenarios on how different sectors would be affected by sudden changes in peak global oil demand, particularly those Canadian financial institutions that are heavily engaged in long-term lending to the oil and gas sector. It could quantify the exposure of pension funds to sudden plunges in the value of carbon-intensive equities. Detailed climate stress testing on the loan books of individual financial institutions could be done in collaboration with the Office of the Superintendent of Financial Institutions.
By conducting and publishing research on different climate scenarios, the Bank of Canada can help raise awareness about the risks Canada’s economy faces from climate change. It can reinforce the importance of preparing for what the Principles for Responsible Investment calls “the inevitable policy response”: the point where governments can no longer delay action on climate change and are forced to take drastic action to move away from fossil fuels.
An economy such as Canada’s, where transition risks are heightened because of carbon intensity, requires a deeper dive when it comes to the threat of climate change. Canada has a well-earned reputation for the prudent management of financial risks. Climate stress testing and scenario research can help keep it that way.