Recommendations for a more practical Standardized Climate Scenario Exercise

OSFI climate scenario response letter from the Canadian Climate Institute

The Office of the Superintendent of Financial Institutions (OSFI) works to maintain confidence in Canada’s financial system. As part of its strategy for guarding against climate-related risks, OSFI has released a draft Standardized Climate Scenario Exercise (SCSE) for public comment. The SCSE looks at the financial consequences of transitioning to an economy powered by clean energy, known as transition risk, and the financial consequences of extreme weather and other physical effects of climate change, known as physical risk. The SCSE identifies four different ways these financial consequences will affect Canadian financial institutions: market financial risk, credit financial risk, physical financial exposure, and real estate financial exposure. In its submission to OSFI, the Canadian Climate Institute identifies the SCSE as an important step forward for aligning Canadian financial institutions with an accelerating clean energy transition and an increasingly volatile climate, and shares recommendations for better optimizing the SCSE’s approach to transition risk and physical risk.

Public submission from the Canadian Climate Institute

The Canadian Climate Institute is an independent research institute that informs and shapes climate change policy in Canada. We have previously analyzed the economic impacts of the global clean energy transition in Sink or Swim: Transforming Canada’s economy for a global low-carbon future and have analyzed the threat presented by a warming climate and the costs and benefits of adaptation in our The Costs of Climate Change series. We appreciate this opportunity to comment on the Office of the Superintendent of Financial Institutions (OSFI)’s proposed approach to climate-related risk management in its Standardized Climate Scenario Exercise (SCSE). 

Climate change threatens Canada’s financial health. Over 70 per cent of the country’s goods exports are vulnerable to transition-driven market disruptions. Meanwhile, the physical impacts of accelerating climate change between 2015 and 2025 alone will slow Canada’s economic growth by $25 billion annually, which is equal to 50 per cent of projected GDP growth. Overall, the SCSE is a positive and important step towards standardizing how federally regulated financial institutions respond to climate-related risk.

This comment letter shares several suggestions for how OSFI can better optimize the SCSE by being more upfront about its assumptions and limitations. While we appreciate that the Exercise is necessarily abstract and aggregated, more clarity is needed to avoid negative unintended consequences.

The SCSE would benefit from additional key assumptions and limitations

Although the SCSE’s existing list of assumptions and limitations is not meant to be exhaustive, it needs further clarifications to how it conceptualizes both transition risk from a changing economy and physical risk from a warming planet. Additional transition risk qualifiers should be acknowledged in the SCSE’s market and credit modules, while in its physical module, additional physical risk qualifiers should be recognized and actively addressed. The same goes for transition risk in the real estate module. We discuss each in turn.

The SCSE’s market and credit modules use an approach similar to the Canadian Climate Institute’s Sink or Swim report for analyzing transition risk. Assuming that OSFI will apply the same transition risk factors as used in the Bank of Canada/OSFI Pilot Project, we broadly support the proposed process. There are additional key assumptions and limitations that the Exercise should disclose, however. 

  • The SCSE should acknowledge that it does not actively analyze opportunities from the clean energy transition and only focuses on transition risk. While opportunities from the clean energy transition are more difficult to quantify than risks in these types of stress-testing analyses, they can give federally regulated financial institutions important insights on strategically managing risks in the transition. We addressed the same limitation in our own analysis of transition risk by complementing the Sink or Swim report with a study of opportunities at the provincial level
  • The SCSE should acknowledge that it does not account for regional differences within Canada. We assume that the SCSE will follow the Bank of Canada/OSFI Pilot Project, and not conduct analysis at the subnational or local level. This limitation is understandable, but its implications should be disclosed and assessed.
  • The SCSE should standardize more assumptions when it comes to mapping counterparties to sectors. The amount of autonomy currently devolved to federally regulated financial institutions may result in fragmented and inconsistent counterparty mapping, particularly for the mapping of “support” counterparties. Clarifying boundaries around the oil and gas sector and its supporting activities has been a major component of our work on Canada’s green and transition finance taxonomy. The European Union sustainable activities taxonomy similarly distinguishes and discloses criteria for activities that enable other activities.

Turning to the physical module, the SCSE may be interpreted as using physical risk to identify financial exposure. However, in its current form, the module only captures physical exposure to hazards, not physical risk. The SCSE should address several key assumptions and limitations to elevate its physical exposure analysis to physical risk analysis.

  • The SCSE should disclose challenges and limitations for translating Representative Carbon Pathways into physical hazards and physical exposure. Current publicly available data, such as that available from Climate Data Canada, is inadequate for assessing physical exposure to important physical hazards such as flooding and wildfires. Translating the warming and climate projections associated with the Intergovernmental Panel on Climate Change’s Representative Carbon Pathways into localized physical hazard and exposure data would be a significant improvement but a major undertaking.  The current limitations of physical hazard data and the challenges involved in conducting robust physical exposure analysis should be clearly explained. 
  • To capture physical risk, the SCSE would have to go beyond physical exposure by also incorporating physical vulnerability to physical hazards. Physical risk is determined by both the physical exposure of assets to physical hazards as well as the physical vulnerability of those assets to the physical hazards to which they are exposed. Currently the SCSE does not address the latter. In order to paint a useful picture of the physical risks facing financial institutions, the SCSE will need to provide guidance on how to analyze the vulnerability of exposed assets and how to incorporate that vulnerability in assessments of physical risk. 
  • The SCSE should pilot a risk assessment approach for a small number of highly material physical risks, rather than to require broad hazard exposure assessment with limited value. Investing in extensive physical hazard mapping and broadly assessing exposure to physical hazards may have little value, as described above. We recommend that the SCSE instead focus on assessing a small number of highly material risks or a single risk, such as that associated with flooding, with a methodology that also incorporates asset characteristics. This will be a challenging undertaking but the results will be much more valuable and there will be important lessons learned about how to, over time, design and implement an effective physical risk assessment methodology that addresses a broad spectrum of risks.

Finally, the SCSE’s real estate module aims to analyze transition risk, similar to the market and credit modules. It has a similar flaw to the physical module, however, as it also presents exposure as risk.

  • To capture transition risk, the SCSE should go beyond power sources and greenhouse gas emissions intensities. It is understandable why the SCSE would need to start with power sources and emissions intensities, given the lack of relevant granular real estate data available in Canada. However, we see these metrics more as fundamentals for having usable data, rather than as indicators of transition risk. The real estate module should at least include scenario pathways for power and building sector emissions (e.g. energy efficiency standards, carbon pricing increases).
  • The SCSE’s understanding of transition risk for real estate should incorporate climate policy as a whole. Policies that increase transition risk for real estate should be balanced against policies that mitigate risks, such as carbon pricing rebates and labour market retraining. This is particularly important for real estate assets because they are sensitive to domestic policy change as a transition risk driver. By contrast, assets that are more trade exposed tend to be more sensitive to transition risk drivers that alter competitiveness, like changes in global policy, technology, and consumer preferences.

Without more context, the SCSE could misrepresent climate-related risks

Focusing on the risks from the clean energy transition without an analysis of the opportunities can exaggerate anticipated harm from the shift. Commercial investments into activities like carbon capture, hydrogen, bioproducts, and mining may come with transition risk, but the risk may be contrasted with significant market growth. The exaggeration of harm would be more pronounced if the SCSE proceeded with only national-level data. The risks and opportunities in the clean energy transition vary widely among provinces, with British Columbia, Manitoba, and Quebec having a significant clean electricity headstart thanks to existing hydro resources.

Conversely, focusing on risks without accounting for the distribution of opportunities can underestimate harm to Canada’s competitiveness. The SCSE suggests that transition risk is negligible in its baseline current policy scenario because it assumes no new climate policies. This overlooks how technology and consumer preferences may continue to evolve towards cleaner energy sources, driving transition risk in markets. It also overlooks how the current policy environment may put other countries on trajectories to outcompete Canada in clean energy-related markets, even if no new policies were to be added.

Equating exposure with risk in the physical and real estate modules without clarifying the limitations of this assumption may also misrepresent risk. Without accounting for physical vulnerability to physical hazards, the SCSE may drastically mischaracterize physical risk. For example, an assessment of physical exposure alone might flag a commercial building in a flood zone as being at risk, but further investigation of physical vulnerability could reveal that the building is only exposed to a minor depth of flooding and has floodproofed to that depth, and therefore is not at risk of flood-related damage. In a similar vein, the Exercise may mischaracterize transition risk for real estate by basing it only on power sources and emissions intensities, which are more reflections of exposure than of risk. For instance, some emissions-intensive households may receive support to help them navigate the clean energy transition.

The SCSE should refine its approach towards transition risk and physical risk to avoid negative, unintended consequences for the financial system

We understand that OSFI will add more detail to the SCSE as it evolves; this letter is intended to draw attention to specific details that should be included in these future iterations. Ideally, the Exercise should provide a more sophisticated analysis of transition risk and physical risk. In the meantime, it should be careful not to overrepresent its current level of sophistication. 

Even though the SCSE cautions that it is not a sizing of climate-related risks, the way it frames these risks could still influence policy and capital allocation. Market and credit risk decision makers may use it to inform their climate-related analysis, without noting the importance of opportunities or subnational differences in the clean energy transition. The Exercise’s physical exposure analysis may also encourage physical risk decision making without adequate consideration of other factors that interact with physical exposure to determine risk level, including characteristics of the asset (e.g. presence or absence of a basement, building materials used) and measures already taken to mitigate risk. Similar concerns also apply to the SCSE’s real estate transition exposure analysis potentially being used to assess transition risk without a fuller accounting of risk factors.

The SCSE is ultimately an important step toward standardizing the identification and management of climate-related risks. It is also a step that would be expected from OSFI, as other financial regulators are taking similar actions. For instance, the European Banking Authority is in the process of developing templates and guidance for climate scenario analysis. As currently written, however, the SCSE is oversimplified, making its use a major undertaking without clear practical value for federally regulated financial institutions—particularly for institutions that already have experience with basic scenario analysis. Going forwards, we recommend that OSFI be clearer about the assumptions and limitations that its Exercise contains and how it intends to improve its accuracy and applicability over time.