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As a country, Canada stands to gain more than most by preparing for the transition to a lower-carbon economy. Energy and other carbon-intensive sectors play a large role in the Canadian economy. As a major exporter, the country is vulnerable to shifts in the carbon policies and preferences of its trade partners. Canadian investors and regulators are aware and have been refining guidance on climate risk and moving closer, in a variety of ways, to making climate risk and TCFD reporting mandatory.
Better climate reporting and disclosure will improve the likelihood of a smooth transition to a lower-carbon economy, rather than a disruptive and disorderly reallocation. In August 2019, Canadian Securities Administrators (CSA), which represents and advises provincial and territorial securities regulators, issued guidance on climate-related disclosure which largely mirrors the Task Force on Climate-Related Disclosure (TCFD) framework. In May, the Trudeau Administration announced the Large Employer Emergency Financing Facility emergency loan program that requires borrowers to report climate risks and carbon mitigation plans. Large investors, including Canada’s public pension fund, CPP Investments, are affirming commitments to the importance of climate risk in investment decisions.
“Climate risk disclosure is not only what global investors and regulators are looking for, but it also reveals metrics that can inform business strategy and prepare companies for the coming carbon-constrained economy,” said Selina Lee-Andersen, a partner in the Vancouver office of law firm McCarthy Tétrault who co-authored a post on this topic recently.
Finally, a rising wave of action by regulatory bodies around the world will have major repercussions for Canadian markets. In a recent letter to financial firms, the head of the Bank of England’s Prudential Regulatory Authority (PRA) wrote that firms must have “fully embedded” their approaches to climate risk by the end of 2021. Mark Carney, the former governor of the Bank of England recently returned to Canada where he will add more wind to the sails of those seeking better measurement and management of climate change. In his roles as the UN’s Special Envoy on Climate Action and Finance and leading ESG investing at Brookfield Asset Management, he is keen to ensure Canadian asset owners, pension funds, sovereign wealth funds, and others are on the right side of history and avoid the tragedy of the horizon.
Scenario Analysis To Take Center Stage
Scenario analysis will be a vital tool to enable firms to meet climate risk reporting mandates. Scenario analyses are modeled constructs—not forecasts or predictions—that explore alternative outcomes that may alter the way businesses and markets operate.
The TCFD framework recommends the use of climate scenario analysis to help firms explore the potential range of climate-related outcomes and analyze the impact of these alternative states of the world on the business in a structured manner, as well as how the business may respond in these circumstances. However, many models currently employed by banks, insurers, and financial institutions were not designed to incorporate the effects of climate change. The Bank of Canada’s recent and pivotal discussion paper demonstrates its understanding of the importance of scenario analysis and the role this work will play in preparing financial markets for climate change impacts.
Scenario analysis should be designed to deliver strategic and actionable insights specific to a company and sector. An investor in real assets may want to understand the potential risk from climate change to market value and even insurability in a property portfolio. An airline may wish to understand which destinations are likely to fall out of favor as climate impacts worsen. A food and beverage company may want to know where risk lies in the supply chain of the agricultural crops they rely on for their goods. And an energy company may want to quantify the benefits of investing in renewable power as regulations make fossil-fuel generation unprofitable in some cases.
Transition Risk’s Central Role in Canadian Climate Risk Assessment
Given Canada’s goal to decarbonize by 2050, assessing transition risk has been a priority for a variety of industries. A survey last year by Chartered Professional Accountants Canada of 40 TSX listed firms found that 70% disclosed the transition risks reflected in changing energy and climate policies while 58% disclosed physical climate risks. In particular, utilities and other energy-dependent sectors have made progress in analyzing transition risks and opportunities.
“The financial sector and the tech sector seem to be fairly well ahead, compared to others. For tech firms, it just seems to be part of their culture to be progressive in how they approach their operations, and they want to demonstrate resilience to their shareholders,” says Rick Alsop, an advisor for climate change and resilience with the environmental engineering firm WSP.
Transition risks tend to increase over time the longer economies wait to transition to greener policies, as sectors have less time to adapt. We routinely see certain transition risks—like carbon pricing and litigation risk—surpassing the financial costs of physical risks in lower emissions scenarios. In contrast, in higher emissions scenarios, financial impacts from physical risks are often more dominant over the course of the century.
The resultant ‘dance’ that occurs between physical and transition risks over time underscores the importance of modeling, visualizing, and analyzing both these types of risks and opportunities side by side, to obtain a full and accurate picture of financial impacts.
Assessing physical risk is challenging for a variety of reasons, including the complexity of the environmental impacts, and because doing so involves asset-level modeling, for companies that own, lease, or invest in hundreds, thousands, or millions of diverse assets.
Canada is Quickly Moving up the Climate Curve
Canadian investors and banks are waking up to the reality that climate risk is the largest unmeasured risk on the balance sheet of most companies, and they are increasingly asking tough questions of the businesses that they invest in or lend to.
“Companies that are looking for access to capital, that want the attention of large institutional investors such as pensions funds, are addressing climate risk through TCFD to secure long-term capital,” said Babar Moghal, director, sustainability & climate change for the Toronto-based consultancy Sustainability-Next.
Rising investor pressure, expanding regulation, and more frequent and severe catastrophic weather events mean that climate risk analysis will soon be central to corporate and investment strategy. As climate risk reporting moves from a voluntary activity to a widespread practice that can confer significant competitive advantages, Canadian companies embracing these changes will be empowered to move beyond business as usual and lead the transition to a lower-carbon economy.
Joseph Lake is COO of The Climate Service.