Are Canadian financial institutions sufficiently prepared for their climate risks?

The Northern Hemisphere has emerged from the hottest summer on record. Almost every country was impacted by some form of extreme weather this year, and Canada was no exception. More than 18 million hectares of Canadian forest – an area larger than mainland Greece – was destroyed by wildfires in 2023, almost doubling the previous record.¹

As the effects of climate change become more pronounced over the coming decades, the physical risks to Canada’s natural landscape, infrastructure, society and economy are expected to intensify. The question now is, to what extent have Canadian financial institutions factored in the financial impacts of climate change over the short and long-term? And would early action to understand these climate risks limit impacts, or even present opportunities?

From a financial institution’s perspective, there are three distinct types of climate risks:

• the impact of the transition to a low-carbon economy (transition risk)
• the physical effects of climate change (physical risk)
• the effects of financial institutions pricing-in transition and physical risks alongside the cascading effects of sudden shifts in market sentiment (market risk)

The Canadian economy is particularly vulnerable to climate transition risks.

In 2020, the Bank of Canada undertook a scenario analysis to better understand the transition risks of climate change, particularly how the economy and financial system would likely be impacted.² Included in this project was the development of a set of four Canada-relevant climate transition scenarios that explore pathways consistent with achieving certain climate targets over a 30-year horizon. From this study and others, including by Ortec Finance’s climate scenario analysis solution, it is clear that Canada is acutely exposed to transition risks. As the fourth largest oil producer globally, the oil and gas extraction sector contributes to more than five per cent of Canada’s GDP and tax revenue, supporting hundreds of thousands of jobs and representing more than 20% of the market capitalization of the Toronto Stock Exchange.³

Recent analysis by the International Energy Agency⁴ suggests that, even under a stated policies scenario, demand for oil is expected to peak before the end of this decade, as low-carbon technologies and policies take effect and electric vehicles replace petrol and diesel cars. This is a hugely positive development for society as a whole and indicates that policy action and technology developments are starting to have an effect. However, as oil demand reduces in line with the transition to a more low-carbon economy, sources of fossil fuels that are most costly to extract, such as oil sands in Canada, are expected to be cut significantly. This will create considerable challenges for the Canadian economy, with repercussions for the financial sector.

What about physical climate risks?

As increasing levels of greenhouse gas emissions in the atmosphere will drive global climate extremes on an unprecedented scale, the long-term physical risks of climate change to Canada’s economy, financial system and society at large are radically uncertain.

Canada’s vulnerability to both transition and physical risks will, no doubt, heighten market risks further. Sudden shifts in market sentiment to price-in both transition and physical risks, as well as the possible knock-on effects throughout the financial system following a rapid devaluation of fossil fuel assets, such as oil, could trigger a financial crisis.

How can this be addressed?

With Canada being highly exposed to these aforementioned climate-related risks, it is vital that its financial institutions prepare their investments by thoroughly assessing and understanding these risks, along with their implications. By taking swift action to understand and prepare, Canadian institutions can not only limit their exposure to financial shocks driven by a stranded assets crisis, but also focus on possible opportunities to tilt investments towards certain less vulnerable asset classes and sustainable benchmarks. Another example could be to capitalize on Canada being a significant source of critical minerals and metals that are key to enabling a low-carbon transition, as backed by the Canadian government in their Minerals and Metals Plan.⁵

An effective way to gain undertake this assessment is through climate scenario analysis.

Climate scenario analysis is a useful modeling approach that assesses investment portfolios under varying possible future climate pathways, as well as economic and market developments, to evaluate climate-related financial risks and identify opportunities. These analyses can help investors appropriately prepare for the effects of physical risks, the implications associated with a rapid low-carbon transition, as well as the market response to both.

Ultimately, Canadian financial institutions have a unique opportunity to lead by example in understanding and addressing both physical and transition climate risks. By acknowledging the direct impacts of climate change and incorporating them into investment decisions, financial institutions can mitigate financial losses, enhance long-term performance, and contribute to the resilience and sustainability of the Canadian economy.

Learn more about our Climate Scenario Analysis Solution - ClimateMAPS