Climate Trends: Canada’s regulator challenges financial institutions to tackle climate risks

January 20, 2022

The Office of the Superintendent of Financial Institutions has a plan to harden banks, asset managers, and similar firms to the rigors of climate change

This year promises to be one of transformational change for Canada’s financial sector. 

On January 14, the Office of the Superintendent of Financial Institutions (OSFI) published a wide-ranging plan to prepare financial firms for the perils and pitfalls that climate change may bring about. A key part of this plan is new climate risk management guidance for federally regulated financial institutions (FRFIs) — such as banks, loan companies, and insurance firms — which the regulator will release for consultation later this year.

OSFI said the guidance aims to fulfill five prudential objectives: 

  1. Awareness: Ensuring climate risks and their impacts are understood throughout each FRFI
  2. Governance and strategy: Incorporating climate risks in each FRFI’s overarching strategy, risk appetite, and risk governance framework 
  3. Risk management: Integrating material climate risks into each FRFI’s enterprise risk management process and making sure they are managed accordingly
  4. Financial resilience: Ensuring each FRFI has enough capital and liquid resources to withstand “severe yet plausible climate risk scenarios over extended time horizons”
  5. Operational resilience: Maintaining FRFI critical operations through disruptions triggered by climate-related disasters

OSFI added that the guidance will reflect its “risk management expectations” of FRFIs, which implies it will intervene if a firm fails to implement them appropriately. Peter Routledge — the head of OSFI — said as much in a speech at a financial industry conference on January 10: “Our climate risk management surveillance will reward better, more mature climate risk management and ultimately punish poor or inadequate climate risk management practices,” he cautioned.

In the same speech, Routledge said that FRFIs will be expected “to build up their capital buffers in the 2020s to be able to weather an accelerated and volatile transition pathway in the 2030s, should that scenario come to pass”. This should push climate risk management front of mind for banks, insurers, and other OSFI-regulated firms. Capital is a scarce resource, and the more FRFIs have to hold against potential losses, the less they have to expand their balance sheets. The possibility of future capital requirements, therefore, gives institutions an economic incentive to get a handle on their climate risks.

To help FRFIs on their way, OSFI and the Bank of Canada (BoC) released the results of a climate scenario analysis project, which put a spotlight on the biggest climate risks Canada’s financial sector could face. The project, which OSFI and BoC ran with six major Canadian FRFIs last year, set out to identify a range of potential economic and financial outcomes that could arise through climate change. Among its findings, the project identified a disorderly climate transition — where the world economy first delays, and then rapidly implements, a low-carbon shift — as a major source of financial risk.

Tellingly, the project also revealed that the scenarios’ estimated climate-related economic impacts for Canada are “driven mostly by declines in global prices of commodities brought by changes in global climate policy”. This implies that no matter what happens at the domestic level as regards climate policy, Canada will still be impacted because of the interconnectedness of its economy and financial system with other countries. 

OSFI and the BoC said the project helped participating institutions “identify data gaps, explore new methodologies and develop a deeper understanding and awareness of the impacts of the climate transition on their portfolios”. The baton now passes to Canada’s financial institutions as a collective to build on this experience and improve their climate risk management — for example, by working to standardize risk assessment methodologies and bridging data gaps. Doing so before OSFI brings informal climate risk management expectations could help minimize their exposure to regulatory intervention. Working together also makes sense in order to spread the burden of effort — as OSFI and the BoC remarked, the project’s participants “required significantly more time and resources than they expected” to complete the scenario analysis.

Some institutions are already taking steps to pool their climate risk knowledge and expertise. Earlier this month, the National Bank of Canada and Royal Bank of Canada joined 17 US banks and the Risk Management Association to form the Climate Risk Consortium, which aims to “develop standards for banks to integrate climate risk management throughout their operations”. Through such collaborative efforts, Canadian banks may be better positioned to fulfill upcoming regulatory expectations. 

Canadian regulators’ climate risk efforts will not stop at FRFIs, though. On December 16, Prime Minister Justin Trudeau told the Deputy Prime Minister and the Minister of Environment and Climate Change that the Government of Canada would “move toward” compulsory climate-related disclosures based on the Task Force on Climate-related Financial Disclosures recommendations. Last year, the Canadian Securities Administrator also issued draft rules on mandatory climate-related financial disclosures for public companies, which are due to kick in from 2023. 

Taken together, these various regulatory initiatives point to a whole-of-economy approach to climate risk management and climate-related financial disclosure, one which the financial sector should embrace, rather than resist, in order to flourish.