Guideline B-15 and climate-related risk: What Canadian lenders need to know
Guideline B-15 and climate-related risk: What Canadian lenders need to know
The Office of the Superintendent of Financial Institutions (OSFI) has introduced new guidelines for financial institutions to incorporate climate-related risks into their stress-testing frameworks.
This includes integrating climate risk considerations within their governance structure and increased transparency through disclosing climate-related financial information.
We explore the new guidance in-depth, breaking down OSFI requirements, including:
- considerations for developing climate stress testing models,
- implications of the proposed standardized climate scenario exercise, and
- our team’s immediate takeaways for financial institutions.
Amid the growing significance of climate-related risks, the Office of the Superintendent of Financial Institutions (OSFI) introduced Guideline B-15. This new guideline emphasizes the need for financial institutions to incorporate climate-related risks into their stress-testing frameworks.
In addition, OSFI also published a consultation paper in April for a Standardized Climate Scenario Exercise.
OSFI’s primary goals through these measures are to:
- Increase understanding of potential exposures to climate-related risks\
- Build capacity to conduct scenario analysis and risk assessments, and
- Measure the potential financial exposures to climate-related risks
This article provides insights into the general approach to climate risk stress testing. It also examines OSFI’s proposed Standardized Climate Scenario Exercise (SCSE), outlining the expectations and general practices for financial institutions.
Climate risk stress testing framework under B-15
What is required by OSFI?
Guideline B-15 provides a comprehensive framework for financial institutions to identify, understand, manage and measure climate-related risks.
To satisfy this framework, institutions must integrate climate risk considerations within their governance structure. This includes board oversight and clearly defined responsibilities for senior management. Institutions must also incorporate climate-related risks into their existing risk management frameworks. This involves identifying, assessing, and managing physical and transition risks associated with climate change.
OSFI is also encouraging institutions to enhance transparency by disclosing climate-related financial information. This includes both qualitative and quantitative disclosures in line with international standards, such as the Task Force on Climate-related Financial Disclosures (TCFD).
What are the general considerations for developing climate stress testing models?
Developing a climate stress testing model requires a structured approach that thoroughly addresses physical and transition risks. Following are key technical considerations for physical and transition risk modelling risk modelling:
Physical risk modelling
- Flood risk modelling: Flood risks can be quantified by integrating detailed geographic data, such as floodplains, river basins, and historical flood frequencies. Institutions may leverage advanced simulation tools to model various flood scenarios and assess potential impacts on owned physical assets/infrastructure and those relating to the financial institution (e.g., collateral underlying lending agreements).
- Wildfire risk modelling: Wildfire risks can be modelled by analyzing fuel availability (e.g., vegetation type and density), weather conditions (e.g., temperature, humidity, and wind patterns), and historical fire data. By simulating the likelihood and spread of wildfires, institutions can assess the impact on properties, infrastructure, and overall portfolio exposure, helping to prepare for and mitigate the potential financial fallout.
- Other physical risks: Other location- and operations-specific risks include hurricanes, droughts, and extreme heat. These risks are modelled by combining historical data with predictive analytics to simulate the frequency and severity of such events under various climate scenarios. This can help institutions evaluate potential disruptions and financial impacts, and ensure they can implement effective risk management strategies.
Understanding the evolution of physical risks due to global warming
Physical risks will change as the planet continues to warm. Climate-related hazards such as floods, wildfires, and extreme heat will intensify and become more frequent as global temperatures rise from 1.5°C to 2°C and beyond.
Knowing the current exposure to these risks is important, but understanding how these risks may evolve is equally vital for developing long-term strategies. Institutions should consider how their risk profile might change under different warming scenarios to effectively plan for future climate risks and remain resilient.
Transition risk modelling
The mainstream approach to transition risk modelling focuses on evaluating the credit risk associated with a financial institution's loan portfolio.
Clients in climate-sensitive industries or those with substantial carbon footprints are particularly vulnerable. Disruptions in production, increased borrowing costs, and changes in credit ratings may require substantial investments and can significantly impact their financial stability. This, in turn, affects the credit risk of financial institutions with loan portfolios that have exposure to these companies.
- Impact on production and operations: Industries might face production challenges or increased operational costs due to the transition to a low-carbon economy. These disruptions could stem from stricter environmental regulations, higher costs for carbon emissions, etc.
- Investment requirements: Companies may face significant costs to reduce their carbon footprint and comply with new regulations — e.g., investing in cleaner technologies, shifting to renewable energy sources, altering their business models, etc. These investments may strain the company’s financial resources and impact its financial well-being.
- Borrowing costs and credit ratings: Industries facing transition risks could see borrowing costs increase due to perceived higher risks by lenders. Additionally, the credit ratings of companies within these industries might be downgraded if they can’t adapt to the changing environment or the transition compromises their financial health.
Mispricing of risks could expose financial institutions to sudden and large losses. It could also delay investments needed to mitigate the impact of climate change.
Proposed standardized climate scenario exercise (SCSE) by OSFI
OSFI is also aiming to develop a standardized climate scenario exercise to ensure climate risk assessments are consistent and comparable across the Canadian financial sector.
Specifically, OSFI outlined three key objectives:
- Raising awareness and strategic orientation: OSFI wants federally regulated financial institutions (FRFIs) to better understand potential exposures to climate change. It sees the SCSE as a starting point for better climate risk quantification.
- Building capacity for climate risk assessment: The SCSE encourages FRFIs to develop the necessary infrastructure for identifying and quantifying climate-related risks. This includes mapping exposures to climate-relevant sectors using NAICS codes or geocoding.
- Establishing standardized quantitative assessment: Through the SCSE, OSFI is looking to apply learnings from the 2021 Bank of Canada/OSFI pilot project, standardize climate risk assessments, and ensure consistency and comparability across financial institutions.
This standardized approach is a foundational step in OSFI's efforts to systematically address climate risks and prepare the financial sector for current and future challenges related to climate change. It’s important to note that SCSE does not replace financial institution’s internal assessment of their climate risk.
What are the proposed requirements by OSFI?
Transition risk for commercial exposure
The SCSE discusses the impact of climate transition risks on commercial exposures — specifically how these risks can translate into financial losses for FRFIs. It explores the multiple ways climate transition scenarios can affect financial markets, and how these risks can negatively impact FRFI investment and asset values and increase the likelihood of defaults.
It considers three different climate transition scenarios:
- Below 2℃ immediate: Immediate policy actions to limit global warming to below 2℃ by 2100.
- Below 2℃ delayed: Delayed policy actions with strong measures taken after 2030.
- Net-zero 2050 (1.5℃): Ambitious actions to limit warming to 1.5℃ by 2100, including net-zero commitments.
Using data from the Network for the Greening of the Financial System (NGFS) and the Bank of Canada, these scenarios reflect varying degrees of transition risks against a baseline scenario based on current policies. The Bank of Canada data is tailored to the Canadian economy while NGFS data offers a broader global perspective.
OSFI also classified exposures into 25 industry sectors and several regional sectors (e.g., Canada, U.S., Europe) for assessing climate transition risks. This classification allows for a sectoral approach to evaluating the impact of climate transition scenarios, which avoids the complexities of counterparty-level analysis.
Credit Risk Module
OSFI has introduced a credit risk module to assess how climate scenarios impact the expected credit loss (ECL) for commercial exposures (e.g., corporate bonds, preferred shares, corporate and commercial lending.) The baseline ECL is calculated using forward-looking macroeconomic scenarios as per IFRS 9. It represents the lifetime ECL for each exposure.
Different climate scenarios will inform adjustments to the probability of default (PD) and loss given default (LGD). Factors informing these adjustments include the company’s region, industry, and credit quality bucket. They will come directly from OSFI.
Market Risk Module
OSFI has also introduced a market risk module that evaluates the impact of transition scenarios on the market value of financial assets. The module focuses on equity and interest rate risk for publicly listed common shares, corporate bonds, and preferred shares that are part of an FRFI’s trading book — or accounted as fair value through profit or loss (FVTPL).
The module prescribes paths for baseline equity prices and instantaneous equity shocks for the three climate transition scenarios. It would be deployed for equity risk assessment, changes in corporate credit spreads, and to assess the potential interest rate impact on 10-year government bond yields. The shocks are also prescribed by OSFI directly.
Transition risk for real estate exposure
SCSE addresses the assessment of climate transition risks specific to real estate exposures within FRFIs. It highlights the distinct nature of these risks compared to corporate and commercial exposures, focusing on how the transition to a low-carbon economy may affect real estate-secured lending / investment portfolios.
OSFI identifies three possible transmission channels related to the real estate-specific risks associated with transitioning away from a carbon-intensive economy:
- Energy source of properties: Properties powered or heated by carbon-intensive sources (e.g., fossil fuels, natural gas) could see values decrease as the economy transitions to net-zero emissions. This devaluation could lead to higher PDs and LGDs due to increased loan-to-value (LTV) ratios.
- Increased operating costs: As carbon taxes raise energy prices, borrowers may face higher costs for maintaining and operating properties, increasing financial stress and potentially leading to higher PDs.
- Labour market shifts: Borrowers employed in industries with high transition risks might experience financial hardship, impacting their ability to service real estate loans.
The primary goal is to understand how climate transition risks might impact real estate exposures, particularly focusing on properties’ heating and energy sources. Unlike other modules, the real estate transition risk module does not aim to quantify financial impacts but serves as a foundational exercise for future analyses.
Under SCSE, FRFIs must create province-level summaries of their real estate exposures, categorized by the primary heating and energy sources (fuel-based vs. non-fuel-based). They may use proxies such as provincial-level statistics on heating sources from Statistics Canada as a reference where there are gaps in the data. The assessment also requires summaries segmented by province, exposure type, and LTV buckets for lending exposures.
Physical risk exposure assessment
Lastly, the SCSE discusses the assessment of FRFI’s exposure to physical climate risks. These risks include both chronic and acute hazards that can lead to significant financial losses due to damage to physical assets, which may reduce their value and increase the likelihood of default.
Chronic Hazards are long-term risks that might affect asset values even after repairs (e.g., rising temperatures, gradual sea-level rise). Acute Hazards are sudden events like floods or wildfires that can cause immediate and severe damage and potentially lead to business disruptions and other indirect financial risks.
The module aims to gauge the extent of FRFIs' exposure to physical hazards. It does not attempt to quantify financial impacts such as credit risks. Rather, it serves as a preparatory exercise for future climate scenario analyses.
SCSE does not require FRFIs to report physical risk information at the individual asset level. Instead, they will aggregate exposures by regions, exposure types, LTV buckets, and hazard-specific metrics (e.g., flood depths, wildfire hazards). The aggregated amounts include exposure amounts and, if applicable, undrawn amounts.
Initial takeaways from the proposed SCSE
Several key takeaways stand out in the SCSE that we think financial institutions should consider. These insights will help institutions align with the regulatory requirements while enhancing their climate risk management capabilities.
- Utilizing ECL framework: Tailoring the ECL model to meet the SCSE requirements involves aligning it with the original ECL model used for IFRS 9 financial reporting purposes. This ensures consistency and accuracy in the estimation of credit losses under different climate scenarios. Institutions can adjust the ECL framework to incorporate transition risks and physical risks while maintaining the integrity of the overall credit risk assessment.
- Utilizing existing market risk framework: Leveraging the existing market risk frameworks to accommodate the SCSE requirements — specifically, price value of a basis point (PV01) and credit spread sensitivity (CS01) calculations — is crucial.
- Geographic information assessment: Complete and accurate geographic information within loan portfolios is critical for meeting the proposed SCSE requirements. Institutions must thoroughly review location data (e.g., latitude and longitude of properties and businesses) to understand their exposure to physical climate risks. They should also update or refine geocoding practices to ensure that the information is current and detailed, and provides for an accurate analysis of how climate-related events may affect specific regions.
- Data management policy: A comprehensive data management framework is essential to prepare for the more rigorous climate data requirements expected in future OSFI modifications. This framework should include policies for data collection, storage, and analysis designed specifically for the unique challenges posed by climate risk data.
PV01 measures the sensitivity of the present value of an asset to a 1-basis-point change in interest rates, which is standard in most institutions. CS01 measures the sensitivity of an asset’s price to changes in credit spreads and might be less common in smaller institutions.
For those lacking CS01 capabilities, it is essential to develop or enhance these calculations, as they are critical for accurately assessing the impact of climate transition risks on market exposures.
Data must not only be accurate and reliable but also easily accessible for analysis and reporting purposes. As climate-related risk assessments become more complex, a robust data management system will be crucial for complying with evolving regulatory requirements and for making informed risk management decisions.
Take the next step
As the regulatory landscape evolves, financial institutions must be proactive in integrating climate risk considerations into their operations. Developing robust stress testing frameworks and participating in standardized climate scenario exercises are critical steps in this process.
Whether your institution is just beginning to address these challenges or seeking to refine existing strategies, MNP can support you on this journey. Contact us to learn more about how we can assist in your climate risk management efforts.
Edward Olson CIA, CPA, CA
Nicole Yue
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