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OSFI Publishes Draft Climate Scenario Analysis Methodology

On October 16, 2023, the Office of the Superintendent of Financial Institutions (“OSFI”) published a draft climate scenario analysis methodology for public comment: The Standardized Climate Scenario Exercise (“SCSE”). This is a foundational step in OSFI’s objective of developing the SCSE workbook, associated instructions, and questionnaire, which will be published in 2024 with the finalized SCSE.

The SCSE draft is just one in a series recent publications from OSFI to guide federally regulated financial institutions (“FRFIs”) in better understanding and mitigating their climate risks. In March 2023, OSFI issued its first prudential climate-related framework as well as a report on climate-change scenario analysis with the Bank of Canada in January 2002. Our review of these developments can be found here and here, respectively.

Comments related to the draft methodology can be submitted to [email protected] until December 22, 2023.

Scope

The SCSE draft applies to FRFIs such as banks and federally regulated insurers. Foreign bank branches and federally regulated pension plans are exempt.

Context

Currently, in Canada, only FRFIs are subject to mandatory climate related disclosure requirements including scenario analysis in accordance with the 2024 and 2025 timelines set out in Annex 2-2 to OSFI Guideline B-15 Climate Risk Management. However, if provincial regulators such as the BC Financial Services Authority (BC FSA), Financial Services Regulatory Authority of Ontario (FSRA) and the Autorité des marchés financiers (AMF) of Québec with jurisdiction to prudentially regulate provincial financial institutions such as credit unions and insurers also adopt a climate-related framework, these regulators may model any required scenario analysis following the SCSE approach for such provincially regulated financial institutions. 

The Canadian Securities Administrators (“CSA”) has said that it is revising the October 18, 2021 draft National Instrument 51-107 Disclosure of Climate-related Matters (“NI 51-107”) which will provide a climate related disclosure framework for reporting issuers in Canada.  If climate scenario is included in NI 51-107, the CSA may also model (adapting for different industries) scenario analysis following the SCSE approach.

Aim & Objectives

OSFI has stated that the SCSE aims to measure climate risks that are arguably not reflected using traditional risk quantification techniques, such as models that use historical experience to measure risks.

OSFI has outlined three objectives for the SCSE:

  1. to raise awareness and encourage strategic orientation with FRFIs to better understand their potential exposures to climate change;
  2. to encourage the building of FRFIs’ capacity to assess the impact of climate-related catastrophic events and policies and to conduct climate scenario analysis exercises and risk assessments; and
  3. to establish a standardized quantitative assessment of climate-related risks, both transitional and physical in nature.

Operational Approach

The publication and use of the SCSE will be comprised of both a top-down (led by public authority) and bottom-up (led by FRFIs) approach. As part of the top-down process, OSFI will develop the SCSE methodology, scenarios, adjustment parameters, and calculations. This information will be shared with FRFIs who in turn, as part of the bottom-up approach, will assess impacts to their exposures using the prescribed information from OSFI.

Overview

The SCSE draft sets out four modules[1] which are generally independent of each other as their overlapping or correlating risks are not considered. The initial exercise of the SCSE draft is to examine the differences in exposure between FRFIs through each module’s specific risks, exposures and scenario narratives.

Each module has an assigned climate risk, which is either transition risk or physical risk. Transition risk refers to the financial risks related to the process of adjusting towards a low-greenhouse gas (GHG) economy, such as changes in government climate policy, changes in market and consumer sentiment towards a low-GHG economy, as well as technological advancements. Physical risks emerge from climate-related extremes and events, such as natural disasters, longer-term shifts in climate, as well as indirect effects of climate change (such as public health implications), which may translate to financial losses.

Each module has an assigned financial risks, consisting of “market risk” for Module 1, “credit risk” for Module 2, and real estate transition risk exposure assessment for Module 3 and 4. Market risk refers to the risk of loss due to market movements, such as changes in interest rates, exchange rates, or stock prices. On the other hand, credit risk refers to the risk of losses in the event that a borrower or issuer fails meet its financial obligations, such as failing to repay a debt.

Each module also delineates the associated exposure (being either the global commercial market exposure or Canadian real estate-related exposure), the scope of exposure to the industry, and relevant asset classes. Finally, each module has a set of unique scenario narratives to perform scenario analysis. This entails identifying a set of hypothetical future scenario narratives and a set of macroeconomic and financial variable projections that capture the quantitative impact of these scenarios.

The SCSE draft provides a list of major assumptions and limitations to its design and execution. While the majority of the assumptions and limitations are unique to each module, the following three assumptions apply to all modules:

  • (1) the intent of the climate scenarios is not to predict the future;
  • (2) a comprehensive sizing of climate risks is not an objective; and
  • (3) there are trade-offs between the standardization of scenario analysis and a comprehensive measurement of each FRFI’s risks.

Module 1: Impact of Climate Transition on Market Risks for Commercial Exposures

Example

Climate Risk

Exposures

Financial Risk

Scope of exposure and asset classes

Impact on value of financial assets

Transition Risk

Commercial (Global)

Market Risk

Exposure: includes equities and corporate bonds in  trading and banking books.

Asset Classes:

  • Other Securities - Corporate Debt

  • Other Securities - Shares

Scenario narratives

This Module 1 will follow four scenario narratives for transition risk. The scenario narratives are based on the ambitiousness and speed at which climate policy is enacted, and are shaped by varied degrees of transition risk and specific data sets. These data sets may include carbon prices, net incomes and change in probability of default. 

Given that there is a degree of uncertainty associated with climate scenario analysis, each of the four scenarios are accompanied by two separate datasets: scenario data developed by the Bank of Canada and scenario data developed by the Network for the Greening of the Financial System’s Phase III scenarios. In other words, each of the following four scenario narratives will be implemented twice using each data set.

  1. Current policies – this baseline scenario aligns with current global climate policies, resulting in negligible transition risk given the lack of climate policy implementation.

  2. Below 2°C immediate – immediate policy action toward limiting average global warming to below 2°C by 2100, resulting in a more subdued transition risk.

  3. Below 2°C delayed – delayed policy action toward limiting average global warming to below 2°C by 2100, resulting in greater transition risk given the eventual implementation of climate policy.

  4. Net-zero 2050 (1.5°C) – more ambitious and immediate policy action (which includes current net-zero commitments by certain countries) toward limiting average global warming to 1.5°C by 2100, resulting in a more subdued transition risk.

Additional Assumptions and Limitations

Transition Risk

  • Static balance sheets are appropriate for an initial and/or standardized assessment of FRFIs’ climate risk.

  • The SCSE draft relies on industry sectors and regional classification based on an assumption of homogeneity within each sector/regional group.

  • The SCSE draft does not consider exchange rate impacts.

  • The underlying assumptions applicable to an industry methodology are assumed when used in this exercise.

Market Risk

  •  Systemic risk channels are not accounted for.

 

Module 2: Impact of Climate Transition on Credit Risk for Commercial Exposures

Example

Climate Risk

Exposures

Financial Risk

Scope of exposure and asset classes

Impact on expected credit loss

Transition Risk

Commercial (Global)

Credit Risk

Exposure: corporate and commercial lending portfolios.

Asset Classes:

  • Other Securities - Corporate Debt

  • Other Securities - Other Debt

  • Small- and Medium-Sized Enterprises (SME) – Commercial Real Estate (CRE)

  • SME - Non-CRE

  • Corporate - CRE

  • Corporate - Non-CRE

  • Bank

Scenario narratives

This Module 2 will follow the same four scenario narratives and datasets for transition risk as described under Module 1. 

Additional Assumptions and Limitations

Transition Risk

  • This Module 2 will follow the transition risk assumptions and limitations listed in Module 1.

Credit Risk

  • Climate transition scenarios may impact assets outside the scope of the credit risk module.

  • The assessment of second-round impacts on an exposure pertaining to finance and insurance is not comprehensive.

  • In a particular calculation, an assumption is made on the agnostic nature of a parameter to climate scenarios.

 

Module 3: Climate Transition Real Estate Exposure Assessments

Example

Climate Risk

Exposures

Financial Risk

Scope of exposure and asset classes

Real estate secured lending and investment portfolios

Transition Risk

Real Estate-related (Canadian)

Exposure Assessment

Exposure: Canadian real estate exposures and mortgage insurance liabilities. For insurers, property insurance liabilities that cover the specific hazard.

Asset Classes:

  • Retail Mortgages - CMHC Insured

  • Retail Mortgages - Other Insured

  • Retail Mortgages - Not Insured

  • Home Equity Line of Credit (HELOC)

  • SME - CRE

  • Corporate – CRE

Financial Risk Exposure Assessment

FRFI’s real estate secured lending and investment portfolios may face financial losses from climate transition risk in the following ways:

  1. Properties that are powered or heating by carbon-intensive sources may be affected by:

    1. Stronger decrease in property value vis-à-vis properties using green energy due to costs required to upgrade the buildings to a more efficient heating source.

    2. Higher stress levels for borrowers due to higher carbon pricing costs which accompany these types of properties.

  2. Borrowers working in industries with higher exposure to transition risks may see additional financial hardship due to shifts in the labour market.

Scenario narratives

There is an assumption with the real estate transition exposure assessment that there will be a transition away from a carbon-intensive economy, but no attempt to specify the timing of the transition.

Additional Assumptions and Limitations

Transition Risk

  • This Module 3 will follow the transition risk assumptions and limitations listed in Module 1.

Real Estate Exposure Assessment

  • This assessment does not consider the potential financial impacts of the climate transition on real estate exposures.

  • This assessment does not consider the impacts of climate transition on a borrower’s ability to maintain their financial obligations.

  • Given the possibility of data gaps in heating and energy sources for real estate exposures, data proxies may be used if collecting this data would pose a significant burden on the FRFI.

Module 4: Physical Risk Exposure Assessments

Example

Climate Risk

Exposures

Financial Risk

Scope of exposure and asset classes associated

Damage to physical assets, impact on asset values.

Physical Risk

Real Estate-related (Canadian)

Exposure Assessment

Real estate exposures: Canadian real estate exposures. For insurers, property insurance liabilities that cover the specific hazard.

Collateralized commercial lending exposures: only exposures valued above a certain threshold (which is to be determined) and secured by immobile collateral physically located in Canada are considered in scope.

Real Estate Asset Classes:

  • Retail Mortgages - CMHC Insured

  • Retail Mortgages - Other Insured

  • Retail Mortgages - Not Insured

  • Home Equity Line of Credit (HELOC)

  • SME - CRE

  • Corporate - CRE

Physical Risk Exposure Assessments 

In trying to better understand the extent to which FRFIs are exposed to certain physical risks, the exposure assessment in this module considers both direct and indirect impacts of physical hazards. Examples of the direct impact include impact on value and likelihood of default in the event that both chronic and acute physical hazards impact physical assets held by FRFIs. Chronic hazards may impact asset values even after repairs are performed while acute hazards may lead to business disruption and property damage.

Scenario narratives

The scenario narratives used here are from the Representative Concentration Pathways (RCP):

  1. RCP 2.6: average rise in temperatures of 0.9 to 2.3°C by 2100, which would require the most action to reduce GHG emissions.

  2. RCP 4.5: average rise in temperatures of 1.7 to 3.2°C by 2100, which would require significant action to reduce GHG emissions.

  3. RCP 8.5: average rise in temperatures of 3.2 to 5.4°C by 2100.

Additional Assumptions and Limitations

  • This assessment does not consider the potential financial impacts of the climate transition.

  • This assessment only considers direct damages on collateralized assets only, although indirect impacts (e.g. business interruptions) may pose even larger risks.

  • The scope of the assessment is constrained to a limited number of physical hazards and will not consider their possible interactions.

 

McCarthy Tetrault’s Expertise

By leveraging our deep industry expertise, we help our clients navigate Canada’s complex, highly regulated financial institutions environment to achieve their business goals, including those engaging the evolving and dynamic environmental, social and governance (“ESG”) and sustainability landscape.  Please contact a member of our Financial Institutions Regulatory Matters group or ESG and Sustainability strategic issues group if you have any questions or for assistance.

 

[1]       The four modules are: (i) Impact of Climate Transition on Market Risks for Commercial Exposures (ii) Impact of Climate Transition on Credit Risk for Commercial Exposures (ii) Climate Transition Real Estate Exposure Assessments and (iv) physical risk exposure assessments.

 

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