Weathering the climate change storm with increased financial risk disclosure: Bank of Canada vulnerability assessment

Why climate-risk disclosure is important 

On May 16, the Bank of Canada published its Financial System Review noting that Canada’s economy is vulnerable to various financial risks, including risks arising from climate change. Mainstreaming climate-related financial disclosure enables organizations to develop strategies that are resilient to various climate scenarios (e.g., temperatures rising by 2°C) and mitigate inevitable climate risks. Organizations are using disclosure as a tool for capital maximization and risk management. 

Meanwhile investors, lenders and insurance underwriters are requesting disclosure to inform decision-making.¹ The Bank of Canada is launching into a multi-year review that will include collaboration with domestic and international partners through the Network for Greening the Financial System. In addition, the Bank of Canada intends to integrate climate-related risks into its financial stability analysis of the Canadian economy and financial system. 

Risks associated with climate change

Economic implications from climate change may range from physical disruptions caused by major weather changes (e.g., rebuilding infrastructure from floods and severe droughts) to transitioning costs arising from adapting to a lower-carbon economy. Some believe the costs may be very high. For instance, the UN Intergovernmental Panel on Climate Change estimated Canada’s cost from climate-related damage amounted to $1.7 billion per year between 2008 to 2017, compared to $200 million per year from 1983 to 1992. Some believe costs are set to rapidly increase for Canada, which is warming at a much faster rate than the rest of the world.²

The Task Force on Climate-related Financial Disclosures (TCFD) notes in its report that transitioning costs are a major climate-related threat to Canada’s financial stability and a concern for banks.³ The TCFD was set up by the Financial Stability Board specifically to develop consistent climate-related financial risk disclosures that may be voluntarily used by organizations to inform their stakeholders. The TCFD estimated in its report that transitioning will require $3.5 trillion in energy sector investments per year.⁴

Carbon-intensive sectors, such as oil and gas, may be particularly susceptible to transitioning costs. The inability to exploit newly discovered fossil fuel reserves due to carbon-laden methods may affect the value of such resources and its production costs on a global scale. Consequently, bank loans may take significantly longer to see any return from carbon-intensive sectors and their supply chains. This creates an ongoing demand for lenders to have access to borrowing institutions financial disclosure relating to climate change.⁵

Demand for climate-related data 

The challenge of predicting the climate means financial impacts from climate change are not easy to quantify, open to debate and subject to mispricing. Mispricing assets can make allocating capital in the transition to a low-carbon economy more costly and may create excessive leverage as a result of rapid repricing. The TCFD suggested that a promising solution to this problem is to have public- and private-sector organizations publicly disclose their financial risks arising from climate change.⁶

Consistent, comparable and reliable climate-related disclosure is in growing demand across jurisdictions to ensure stakeholders are making informed business decisions.⁷ This demand has generated various disclosure standards, such as the TCFD. In June 2017, the TCFD released recommendations of four core elements that should be included in an organization’s disclosure. In just over a year, its recommendations gained the support of over 500 companies. The TCFD report examined four industries (banks, insurance companies, asset managers and asset owners) and found that disclosure by the banks aligned with TCFD’s disclosure recommendations more than any other group.⁸ This is further supported by the fact the Bank of Canada has incorporated climate change into its mandate.⁹

The Carbon Disclosure Project (CDP) is a voluntary global disclosure system that enables businesses to measure and manage their environmental impacts. The CDP has estimated that by 2030, $4 trillion worth of assets is at risk from climate change. However, there is an opportunity to save $53 billion worth of company assets by taking part in the CDP program aimed at reducing a company’s greenhouse gas emissions and climate change risks, and a $5.5 trillion global market for low-carbon goods and services.

Organizations may also look to the Equator Principles (EP) for guidance on when to monitor their environmental risks to ensure responsible risk management and strategic business planning. The EP, published by the Equator Principles Association, offers a risk management framework that sets a minimum standard for due diligence for environmental impacts created by an organization’s projects. Organizations can then make public the modifications they have made to ongoing projects in order to comply with EP environmental standards. There are currently 96 institutions in 37 countries that have adopted the EP, most of which refuse to finance projects that are unable to comply with the EP. 

Conclusion

Climate-related financial disclosure contains a number of benefits for both organizations and their stakeholders, including promoting efficient strategic management, capital allocation and informed decision-making. However, until consistent and comparable disclosure tools reach widespread acceptance among various sectors, mispricing risks may become an issue for Canada’s markets and exacerbate its financial vulnerability to climate change. The Bank of Canada’s vulnerability assessment for climate-related risks highlights the continued need for companies and organizations to prepare for greater climate-related disclosure.

The author wishes to thank summer student Tiana Corovic for her help in preparing this legal update.