Financial institutions and climate risks: Office of the Superintendent of Financial Institutions and Autorité des marchés financiers release their report

On September 11, the Office of the Superintendent of Financial Institutions (OSFI) and the Autorité des marchés financiers (AMF, Quebec's securities regulator) published a joint report on the resilience of financial institutions to climate risks (Report). 

This publication is part of the standardized climate scenario exercise (SCSE), which is a tool for measuring potential exposure to climate-related risks for which more than 250 deposit-taking institutions and insurers with operations in Canada have submitted data.

This initiative had three main objectives: 

• Enhance the financial sector’s understanding of climate-related financial risks.
• Foster the development of climate risk measurement capabilities.
• Provide a standardized, comparable view of physical and transition risks across federally and provincially regulated financial institutions.

The Report notes that, while financial risks arising from climate issues do not pose an immediate threat to financial stability, financial institutions should enhance their data and modelling capabilities to incorporate climate risk into their decision-making processes.

Findings related to physical risks

The first component of the analysis carried out by OSFI and the AMF targets the physical risks caused by riverine and coastal flooding and wildfires.

The flood risk assessment reveals a gap in insurance coverage in Canada. Coverage against this risk is offered as an option, with an underwriting rate of only 40 per cent, which creates direct risks for deposit-taking institutions, life insurance companies and mortgage insurance companies. 

As for property and casualty insurers, their dependence on reinsurance to manage this type of risk is highly variable. This is a major concern, especially if coverage becomes unaffordable or unavailable. 

Some deposit-taking institutions, meanwhile, show a significant concentration of high loan-to-value mortgages in higher-risk flood zones, highlighting pockets of vulnerability in the financial system.

In terms of wildfire risk, the Report predicts the proportion of wildfire zones at high or very high risk will rise from 16 per cent under current conditions to 29 per cent by 2050. While the Report does not conclude that there is a gap in insurance coverage in Canada in this regard, financial institutions remain exposed to indirect impacts similar to those seen with flood risk.

Potential impacts of transition risk

The second component of the Report examines the risks associated with the global shift toward a low-emission economy, particularly with respect to tensions generated by changes in policies, the confidence of economic actors and the associated technologies. 

Sectors facing high transition risks include fossil fuels, energy-intensive industries, agriculture and forestry, and air and other transportation. 

To this end, the Report notes that the longer the transition is delayed, the more likely it is to require rapid and costly changes related to credit risk for financial institutions. The fossil fuel sector is expected to suffer the greatest losses, accounting for up to 83 per cent of total losses, but only 7 per cent of total exposures.

Source: SCSE report – Strengthening Climate Risk Financial Resilience (Figure 12, page 31)

Key points for financial institutions

In light of the above, OSFI and the AMF conclude that financial institutions need to take several steps to bolster their ability to assess and mitigate climate-related risks, including: 

• Investing in climate data and strengthening each institution’s own modelling capabilities to integrate climate risks into management models, taking into account specific vulnerabilities and geospatial and emissions data.
• Promoting adaptation to the physical risks of flooding and wildfires by raising clients’ awareness, providing practical advice and supporting proactive measures.
• Assessing the resilience of reinsurance strategies and fully integrating property insurance and adaptation strategies into risk management practices.
• Developing robust methodologies for quantifying financial losses linked to climatic risks, and extending the analysis to a wider range of financial instruments exposed to transition risks.
• Performing system-wide crisis simulations, integrating macro-financial feedback loops and second-order effects.

In addition, OSFI and the AMF have announced that implementation of the climate risk statement will become a regulatory expectation for all financial institutions concerned as of next year, and other Report findings will also be incorporated.

The Report’s conclusions, as well as the anticipated new regulatory expectations by OSFI and the AMF, could have a significant impact on financial institutions in Canada. Our team is available to answer any questions you may have and to discuss the implications of the Report.

The authors would like to thank Charles-Alexandre Groleau, student, for his contribution to preparing this legal update.