Financial system could be destabilized by stranded carbon-intensive assets, warns Bank of Canada

Editor’s note: This story was originally published by Canada’s National Observer. It appears here as part of the Climate Desk collaboration.

The shift to a low-carbon economy is “underway” and sectors like oil and gas, as well as the banks that loan money to them, are exposed to risks from climate change that could spill over into destabilizing “fire sales,” the Bank of Canada said Thursday.

The central bank listed climate change as one of six vulnerabilities in the Canadian financial system in a report released May 16. The report, called the Financial System Review, marks the first time the Bank of Canada has explored the issue in depth as part of its examination of risks to the nation’s financial stability.

The Bank of Canada’s acknowledgement of climate-related risk in Thursday’s report is significant, given that it’s the institution that promotes economic and financial welfare in the country, including through setting the key interest rate and influencing the money supply.

Few firms disclose the financial impact of climate change. In its report, the central bank recognized that investors are only getting a partial picture of what kind of impact climate change will have on Canadian businesses, because “few firms disclose the financial impact of climate change on their assets and operations.”

It said climate-related risks faced by the financial system “can be managed most effectively when investors and authorities know what exposures firms face and how they are being managed.”

At a press conference Thursday, Bank of Canada Senior Deputy Governor Carolyn A. Wilkins drew a comparison with the 2008 financial crisis. “When risks are priced properly, then their effects when they materialize are usually less. We saw that during the crisis; the opaqueness of markets was difficult,” she said.

“The more we can increase the information that market participants have access to, the better.”

The Financial Stability Board’s Task Force on Climate-related Financial Disclosures has said businesses should publish climate-related risks in annual reports and other disclosure mechanisms.

But an investigation last year by the Canadian Securities Administrators, which represent securities regulators in each province and territory, found that nearly half of publicly-traded firms in Canada that it probed were only disclosing “boilerplate” climate data or nothing at all.

Thursday’s report also noted that when such disclosures do occur, there are “inconsistencies in how firms report climate-related risks across industries and regions.”

International Institute for Sustainable Development (IISD) senior associate Céline Bak has argued that some laws in Canada may actually make it difficult for firms to disclose climate-related risk, as such disclosures may be legally interpreted as speculative.

“There is a question of measurement, and consistency of measurement, that one can imagine, if it’s in an actual financial statement, or in an annual report, you have to think carefully about how that’s presented relative to other information that is more black and white,” said Wilkins.

“That being said, I don’t want to give the impression that we shouldn’t work towards it. It’s a very important initiative.”

Assets in oil and gas sector “may become stranded.” Climate change poses both physical risks from “disruptive weather events,” the central bank said, as well as what it called “transition risks” from decarbonization. “Investor and consumer preferences are shifting toward lower-carbon sources and production processes, suggesting that the move to a low-carbon economy is underway,” it stated.

“Transition costs will be felt most in carbon-intensive sectors, such as the oil and gas sector. If some fossil fuel reserves remain unexploited, assets in this sector may become stranded, losing much of their value. At the same time, other sectors such as green technology and alternative energy will likely benefit.”

In Canada, carbon-intensive assets are pervasive. The Toronto Stock Exchange, along with its sister exchange in Calgary, accounts for more oil and gas firms than any other in the world.

Canadian capital markets hold US$436 billion representing fossil fuel companies, and much of Canadians’ retirement savings and pension funds are also tied up with the sector, according to the IISD.

The think tank has warned that waiting too long to scale back the pollution caused by the burning of fossil fuels like coal, oil and natural gas, which release heat-trapping carbon pollution into the atmosphere, could create an economic shock if markets suddenly factor in adjustments to asset prices.

On Thursday, the Bank of Canada confirmed that “if assets are mispriced, correct incentives will not be in place to manage and mitigate risks.” It said “rapid repricing might cause fire sales and interact with other vulnerabilities — like excessive leverage — destabilizing the financial system.”

The central bank said this asset mispricing “might occur for a variety of reasons,” including “a lack of information on carbon exposures or incentives that are not properly aligned,” as well as the result of “decision makers” who “find it difficult to account for uncertain and complex events in the distant future.”

“Banks have loans to carbon-intensive sectors.” Bank of Canada Governor Stephen S. Poloz first committed on March 27 to build climate-related risks into the central bank’s review process, and to undertake a years-long research effort to strengthen its analytical abilities in this regard. He said at the time that climate change’s impact on financial stability and monetary policy has “become increasingly clear.”

Climate change is leading to more severe and frequent weather events like inland and coastal flooding, wildfires, drought, heat waves and cold snaps. Insured damage to property is climbing, as are insurance rates, around the world. Canadian government scientists say the country is warming at twice the average global rate due to climate change.

In addition to insurance companies, “many other parts of the financial system are exposed to risks from climate change,” the Bank of Canada said in its report. “Banks have loans to carbon-intensive sectors as well as to connected sectors — for example, those upstream or downstream in supply chains. Asset managers hold carbon-intensive assets in and outside Canada.”

The banking regulator in Canada, the Office of the Superintendent of Financial Institutions (OSFI), has said it “expects all financial institutions to quantify their climate risk exposures” as well as develop strategies to manage their transition to lower-carbon assets.

The agency’s expectations aren’t enforced through mandatory requirements. National Observerasked Poloz on Thursday whether the Bank of Canada would recommend such a requirement as part of OSFI’s supervision of federally registered banks and insurers.

“That is a question for OSFI, and not for us,” Poloz replied. “It’s not for us to discuss in public what other sister agencies should be doing (in terms of) their mandate.”

The bank also listed household indebtedness, housing market imbalances, cyber threats, weak corporate debt funding and changes to crypto-asset markets like Bitcoin as financial system vulnerabilities.

The Financial System Review is a flagship publication of the central bank’s Governing Council which includes Poloz and Wilkins as well as deputy governors Timothy Lane, Lawrence Schembri, Lynn Patterson and Paul Beaudry.