Bank of Canada identifies climate change as important economic weak spot

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Vulnerability 5: Climate change

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

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

Climate change creates important physical risks both in Canada and globally. According to the Intergovernmental Panel on Climate Change, the average world temperature in 2017 was around 1°C higher than pre-industrial levels and is projected to rise by 0.2°C per decade. One consequence is an increase in extreme weather events such as flooding, hurricanes and severe droughts. Insured damage to property and infrastructure in Canada averaged about $1.7 billion per year from 2008 to 2017, up from $200 million per year from 1983 to 1992. Canada is particularly affected—it is estimated to be warming significantly faster than the rest of the world.

The move to a low-carbon economy involves complex structural adjustments, creating new opportunities as well as transition risk. Investor and consumer preferences are shifting toward lower-carbon sources and production processes, suggesting that the move 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 unexploited, assets in this sector may become stranded, losing much of their value. At the same time, other sectors such as green technology and alternative energy will likely benefit.

Both physical and transition risks are likely to have broad impacts on the economy. Moving labour and capital toward less carbon-intensive sectors is costly and takes time. Global trade patterns may also shift as production costs and the value of resources change. The necessary adjustments are complex and pervasive and might lead to increased risk for the financial system. In addition to insurance companies, many other parts of the financial system are exposed to risks from climate change. Banks have loans to carbon-intensive sectors as well as to connected sectors—for example, those upstream or downstream in supply chains. Asset managers hold carbon-intensive assets in and outside Canada. The Government of Canada’s Expert Panel on Sustainable Finance is studying these issues.

Limited understanding and mispricing of climate-related risks could potentially increase the costs of transitioning to a low-carbon economy. The risks faced by the financial system from climate change can be managed most effectively when investors and authorities know what exposures firms face and how they are being managed. The Financial Stability Board’s (FSB) Task Force on Climate-related Financial Disclosures recommends that firms publish climate-related financial information. However, this practice is not universal. Few firms disclose the financial impact of climate change on their assets and operations. Moreover, there are also inconsistencies in how firms report climate-related risks across industries and regions.

In addition, asset prices may not fully reflect carbon-related risk, which could also raise the cost of transitioning to a low-carbon economy. Mispricing might occur for a variety of reasons. These include a lack of information on carbon exposures or incentives that are not properly aligned. Mispricing can also occur because decision makers find it difficult to account for uncertain and complex events in the distant future. If assets are mispriced, correct incentives will not be in place to manage and mitigate risks. Rapid repricing might cause fire sales and interact with other vulnerabilities—like excessive leverage—destabilizing the financial system. Better transparency could help alleviate this risk.

Through research and collaboration with partners, the Bank is improving its understanding of climate risks as they relate to the Bank’s mandate. The Bank is working with members of the NGFS. The NGFS’s first comprehensive report, released in April 2019, has four non-binding recommendations related to central banks, including the Bank of Canada:

1. Integrating climate-related risks into financial stability monitoring and micro-supervision. The Bank will develop the tools needed to monitor and analyze climate-related risks, leading to a meaningful assessment of these risks. One approach is to use scenario analysis.
2. Integrating 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. Bridging the data gaps. By participating in the NGFS working groups and other groups, the Bank will help identify data gaps. This will help relevant domestic and international stakeholders focus their efforts to improve the availability of data.
4. Building awareness and intellectual capacity and encouraging technical assistance and knowledge sharing.The Bank is building its analytical capacity as part of a multi-year research plan. To accelerate the plan’s development, the Bank is collaborating 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:

5. Achieving robust and internationally consistent climate and environment-related disclosure, and
6. Supporting the development of a taxonomy of economic activities.

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