Financial System Review – 2019 – Bank of Canada

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Vulnerability 5: Climate change

  • Climate change continues to pose risks to the economy and the financial system. These include the physical risks associated with disruptive weather events and the transition risks associated with adapting to a global low-carbon economy.
  • The Bank is undertaking a multi-year research plan to better assess climate change risks that are relevant to its mandate. This work includes collaboration with national and international partners, such as with the Network of Central Banks and Supervisors for Greening the Financial System (NGFS).

The Bank of Canada integrates climate change risk into its analysis of the Canadian economy and financial system. Economic activity and the environment are closely linked. Most experts agree that the global climate is changing and this has growing implications for the economy. But the range of possible outcomes is wide.

Climate change creates significant physical risks both in Canada and globally. According to the Intergovernmental Panel on Climate Change, the average global temperature in 2017 was about 1 ° C above pre-industrial levels and is expected to increase by 0.2 ° C per decade. One of the consequences is an increase in extreme weather events such as floods, hurricanes and severe droughts. Insured damage to property and infrastructure in Canada averaged about $ 1.7 billion per year from 2008 to 2017, compared to $ 200 million per year from 1983 to 1992. Canada is particularly affected – it is estimated that it is heating up much faster than the rest of the world.

The shift to a low-carbon economy involves complex structural adjustments, creating new opportunities as well as transition risks. Investor and consumer preferences are shifting towards low carbon sources and production processes, suggesting that the transition to a low carbon economy is underway. Transition costs will be felt most in carbon intensive sectors, such as the oil and gas sector. If some fossil fuel reserves remain untapped, the assets of this sector could become stranded and lose much of their value. At the same time, other sectors such as green technologies and alternative energies are likely to benefit.

Physical and transition risks are likely to have far-reaching effects on the economy. Moving labor and capital to less carbon intensive sectors is costly and time consuming. Global trade patterns can also change as production costs and the value of resources change. The necessary adjustments are complex and pervasive and could lead to increased risk to the financial system. Besides insurance companies, many other parts of the financial system are exposed to the risks of climate change. Banks provide loans to carbon intensive sectors as well as related sectors, such as those upstream or downstream of supply chains. Asset managers hold carbon-intensive assets in Canada and abroad. Government of Canada Expert Group on Sustainable Finance study these questions.

A limited understanding and flawed assessment of climate-related risks could potentially increase the costs of transitioning to a low-carbon economy. The risks facing the financial system as a result of climate change can be managed more effectively when investors and authorities know the risks companies face and how they are managed. The Financial Stability Board (FSB) Climate-Related Financial Reporting Working Group recommends that companies publish climate-related financial information. However, this practice is not universal. Few companies disclose the financial impact of climate change on their assets and operations. In addition, there are also inconsistencies in the way companies report climate-related risks across sectors and regions.

In addition, asset prices may not fully reflect carbon risk, which could also increase the cost of transitioning to a low-carbon economy. A pricing error can occur for a variety of reasons. These include a lack of information on carbon exposures or incentives that are not properly aligned. A pricing error can also occur because decision makers struggle to account for uncertain and complex events in the distant future. If assets are poorly valued, the right incentives will not be in place to manage and mitigate risks. A rapid price revision can cause spurious sales and interact with other vulnerabilities, such as excessive leverage, destabilizing the financial system. Better transparency could help mitigate this risk.

Through research and collaboration with partners, the Bank is improving its understanding of the climate risks associated with its mandate. The Bank works with members of the NGFS. NGFS first full report, published in April 2019, contains four non-binding recommendations regarding central banks, including the Bank of Canada:

  1. Integrate climate-related risks into financial stability monitoring and micro-supervision. The Bank will develop the necessary tools to monitor and analyze climate-related risks, leading to a meaningful assessment of these risks. One approach is to use scenario analysis.
  2. Integration of sustainability factors into own portfolio management. The Bank is considering how to integrate environmental, social and governance factors into its investment framework for the Bank of Canada pension fund.
  3. Fill the data gaps. By participating in NGFS working groups and other groups, the Bank will help identify data gaps. This will help relevant national and international stakeholders to focus their efforts to improve data availability.
  4. Build awareness and intellectual capacity and encourage technical assistance and knowledge sharing. The Bank is strengthening its analytical capacity as part of a multi-year research plan. To accelerate the development of the plan, the Bank is working with the NGFS and other groups. The Bank plans to publish its work on the Financial System Hub and as part of the Financial system review.

Two other NGFS recommendations do not fall directly within the mandate of central banks but are important to facilitate their work:

  1. Obtain a solid and coherent disclosure at the international level on the climate and the environment, and
  2. Support the development of a taxonomy of economic activities.
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