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    OSFI Issues Results of Pilot on Climate Risk Scenario Analysis

    The Office of the Superintendent of Financial Institutions (OSFI) published an update on the discussion paper that intended to engage federally regulated financial institutions and other interested stakeholders in a dialog with OSFI, to proactively enhance and align assurance expectations over key regulatory returns. OSFI agrees with respondents that guidance on assurance should be principles-based and risk-based. OSFI plans to consider responses to the discussion paper in preparing and issuing a draft Assurance Guideline on Capital, Leverage, and Liquidity Returns in the first quarter of 2022 and then finalize the guidance by the third quarter of 2022. OSFI also published the results of a pilot project on climate scenario analysis. OSFI announced plans to issue draft guidance on climate risk management for federally regulated financial institutions later this year.

    Together with six Canadian financial institutions, the Bank of Canada and OSFI developed scenarios that will help the financial sector identify, measure, and disclose climate-related risks. The pilot, which was launched in late 2020, built on work by the Central Banks and Supervisors Network for Greening the Financial System (NGFS). While NGFS pioneered the use of scenario analysis to examine climate change risks, the pilot extended that work by looking at potential impact on specific economic sectors. The pilot also provided insight on the maturity of climate related governance and risk management practices of Canadian financial institutions and their level of preparedness for managing risks. More robust management of climate-related financial risks is essential for institutions to better understand how they are exposed to climate change under different potential scenario pathways. The scenarios were not intended to be forecasts or predictions. Instead, they were designed to capture a range of potential outcomes and illustrate the kinds of stresses on the financial system and economy that could occur as the world transitions to a low-carbon future. 

    All scenarios showed that this transition will entail important risks for some economic sectors. Mispricing of transition risks could expose financial institutions and investors to sudden and large losses. It could also delay investments needed to help mitigate the impact of climate change. The scenarios highlighted that meeting climate targets will lead to significant structural changes for the Canadian and global economies and that this transition will be more challenging in countries like Canada that have large carbon-intensive sectors. The analysis also showed that delaying climate policy action increases the overall economic impact and risks to financial stability. An important caveat is that the scenarios make very conservative assumptions about the evolution of green technologies. Therefore, they do not capture potential impact or opportunities of disruptive technologies. The scenarios also deliberately focus on transition risks rather than physical risks. The manifestation of physical risks, and efforts to avoid or mitigate their impact, could also have significant implications for the global and Canadian economies and the financial system. This is an area for future work.

    Both the public and private sectors are in the early stages of building their capacity to assess risks related to climate change. In the future, it will be important to work toward better data collection on exposures and vulnerabilities and for more institutions to employ scenario analysis. Future work could consider, for example, physical risks related to climate change, other types of risk, or larger systemic considerations. For its part, the Bank of Canada plans to build its capacity to assess the implications of more frequent severe weather events and the transition to a low-carbon economy for potential output growth, the labor market, and inflation. Meanwhile, OSFI continues to assess whether its regulatory capital framework needs to reflect the unique features of climate-related financial risks. Through its ongoing supervisory activities, OSFI will reinforce its expectation that federally regulated financial institutions evaluate and measure their capital available to protect against material risks, including climate-related financial risks, and reflect their assessments in the banks’ Internal Capital Adequacy Assessment Process (ICAAP) or the insurers’ Own Risk and Solvency Assessment (ORSA). OSFI will also reinforce its expectation that federally regulated financial institutions consider the implications of both physical and transition risks on their liquidity buffers.

     

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    Keywords: Americas, Canada, Climate Change Risk, Scenario Analysis, Stress Testing, ESG, Reporting, Regulatory Capital, Liquidity Risk, Leverage Ratio, Assurance Guideline, Transition Risk, OSFI

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