Navigating Uncertainty in Climate Change

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Released by the OSFI (or BSIF in french), this paper focuses on risks arising from climate change that can affect the safety and soundness of federally regulated financial institutions (FRFIs) and federally regulated pension plans (FRPPs). Climate-related risks can affect theirs safety and soundness by driving financial, strategic and operational risks and by affecting a FRFI’s reputation. For FRFIs, OSFI agrees guidance on climate-related risks should be principles-based and consider the Canadian context as well as international developments and for FRPPs, OSFI will continue collaborating with the Canadian Association of Pension Supervisory Authorities to develop guidance on integrating ESG factors in pension investment decisions.
Incorporate climate-related risk considerations into policies, procedures and controls. Governance structures, policies or practices may need to be adapted to implement a climate-related risk strategy. Some example of emerging practices include: Designating a Senior Officer accountable for climate-related risk to improve decision-making, Implementing awareness programs to improve the climate-related risk literacy of decision makers, Linking senior management compensation to specific climate-related risk magament objectives of the organization.
Adapt risk management approaches and tools to assess and measure climate-related risks; report on climate-related risks to enable strategy recalibration. A risk management process that defines, identifies, assesses, monitors and manages climate-related risks is key to informing an effective strategy that aligns with financial institutions’ objectives and risk appetite. Traditional risk management approaches and stress testing tools may not be sufficient for identifying and accounting for a financial institution’s climate-related risk exposures due to the uncertain outlook and long-horizon of climate change.
Establish risk appetite for climate-related risks; assess current portfolio and forward-looking business model in relation to risk appetite; develop a strategy for adherence to climate risk appetite that is commensurate with the nature, size, complexity and risk profile of the financial institution; recalibrate the strategy as needed.
Similar to other material risks, appropriate policies, procedures, and controls implemented across the financial institutions’ three lines of defense can contribute to effective climate-related risk management: line of business; risk management, compliance, financial and actuarial functions; internal audit.
Effective governance also requires including climate-related risk in a financial institution’s operational risk management practices. For example, embedding climate-related risk management into a financial institution’s business continuity processes and key outsourcing arrangements can foster proactive responses to climate-related business disruptions and broader operational resilience.
For climate-related risks, traditional financial risk models can present a challenge to financial institution’s in a number of ways: current assumptions may not capture the impact of climate-related risks on the future direction of the risk exposure; historical loss rates due to climate-related risks are not currently available; and climate data available may be insufficient in granularity. Given that risk modelling in the area of climate-related risks continue to develop and evolve, financial institutions may need to consider other ways to assess their material climate-related risk exposures to determine the appropriate level of capital in the interim.
Climate-related risks, and transition risks in particular, can materially change the investment environment over time. Consequently, it is important for the pension plan administrator to assess how the transition to a lower GHG-economy may impact the pension plan’s investment policy and strategy in the longer term. At the same time, climate change may bring about new investment opportunities for pension plan. The pension plans are expected to evaluate any such opportunities in the context of their Statement of Investment policies and strategies, reflecting the plan’s investment objectives and risk appetite.
In cases where the pension plan invests in pooled funds and the administrator does not have control over individual investments held by such funds, the pension plan’s administrator can assess the pooled funds’ consideration of climate-related risk to determine alignment with the pension plan’s risk appetite.
For pension plan where the pension plan administrator directly invests in assets, they can consider the plan’s exposure under a variety of potential climate transition scenarios. For pension plans where the administrator delegates individual investment decisions to an investment manager, the administrator can seek to include climate-related risks considerations in the investment manager’s mandate or choose an investment manager based in part on the manager’s approach to climate-related risks.
Climate related-risks
Climate-related risks can drive financial risks such as credit, market, liquidity and insurance risks for financial institutions and pension plans. They can also lead to strategic and operational risks or reputational damage. Mismanagement of these risks can affect a financial institution’s or pension plan’s safety and soundness.
Credit risks
Damage to collateral for DTI (debt-to-income) loans. GHG-intensive borrowers face higher costs of doing business and/or lower revenue reducing profitability.
Insurance risks
Insurance claims exceed insurance company expectations. Parties against whom the claims are made may seek to pass the cost to insurance companies.
Liability risks
Liability risks relates to potential exposure to the risks associated with climate-related litigation.
Liquidity risks
An institution with a GHG-intensive portfolio may see its creditworthiness in wholesale debt markets diminish as its assets become more illiquid.
Market risks
Physical damage and a perception of heightened risk can affect the market value of investments. Unexpected valuation change in debt and equity securities issued by impacted firms.
Operational risks
Physical damage to premises; outage of critical services or functions (e.g., banks branch, insurance claims department).
Physical risk
Physical risks arises from a changing climate increasing the frequency and severity of wildfires, floods, wind events and rising sea levels, among other things.
Transition risks
Transition risks stems from efforts to reduce GHG emissions as the economy shifts towards a lower GHG-footprint.