Regulator’s pilot project to start scenario-testing for climate change risks

Canada’s solvency regulator has introduced a pilot project in 2021 to conduct scenario testing of the impact of various climate-related risks on financial institutions’ bottom lines.

“The first step of the pilot project is to develop a Canada-relevant set of transition scenarios [representing the transition to a low-greenhouse gas economy], and financial risk assessment methods and metrics,” OSFI Superintendent Jeremy Rudin said in prepared remarks to the Global Risk Institute in December. “We are targeting to complete this step in the first half of 2021.

“Next, using these scenarios, participants will explore the potential risk exposures on their balance sheets. We are aiming to complete this step in the second half of 2021.

“Finally, along with the Bank of Canada, we plan to publish a report near the end of 2021, sharing details on the specific scenarios, methods, assumptions and key sensitivities.”

In his remarks, Rudin said the P&C insurance and other financial industries could draw on lessons learned from the pandemic to help prepare for three different types of climate risk:

• Physical risk: The impact to institutions of direct damage to physical assets from extreme climate events, rising sea levels, catastrophic weather events and the like. For insurers, that could also mean the financial impact arising from higher property insurance claims; reductions in the value of investments; or from the reduced value of loan collateral.
• Liability risk: The impact on insurers that bear the consequences of third-party claims for damages caused by climate change. “Similar to what we have experienced during the pandemic with business interruption insurance claims, this risk will not be readily quantifiable until a variety of legal actions make their protracted way through the courts,” Rudin said.
• Transition risk: The transition to a low-greenhouse-gas emission economy will affect P&C insurers in the future through the policy responses that Canadian and foreign governments will implement to lower greenhouse gas emissions, as well as changing investor and consumer preferences.

The pandemic and climate risk are similar in the sense that many aspects of the risks remain unknown, even as they unfold before us, as Rudin pointed out.

Regarding the pandemic, “a number of people have asked me, ‘Jeremy, didn’t you have a pandemic plan?” Rudin said in his prepared remarks. “We did, and the financial institutions had pandemic plans as well. We just did not have a plan for this particular pandemic.

“At OSFI, for example, we had stocked up on masks and gloves because we had a plan for a pandemic where everyone continued to work in their usual way while taking extra precautions to avoid catching or spreading the disease. That is a type of pandemic, but it is not the pandemic that we are now living through.

“Fortunately, the Canadian financial sector had the capital resilience, the liquidity resilience and the operational resilience to navigate the current pandemic, aided by very strong support from our fiscal and monetary authorities. We have seen that the financial sector was prepared for a sufficiently wide range of severe but plausible scenarios, that it was ready for the current disruption even though we did not foresee all the details.

“The same needs to be true of our preparations for climate-related risks. We know that the climate will continue to change. Yet that does not tell us which climate-related events will have significant impacts on the financial sector nor when those events will occur.”

Feature image courtesy of iStock.ca/Nastco