Climate Risk Awareness

editorial

The Bank of Canada is working with international partners to develop strategies to mitigate transition risks and promote sustainable finance

CLIMATE RISK AWARENESS

BY CARLA GILES, EXECUTIVE DIRECTOR, CMBA-BC AND MBIBC; CO-EXECUTIVE DIRECTOR CMBA

Populations across the

globe are experiencing the adverse effects of climate change with an increase in the number and severity of weatherrelated events, rapid biodiversity loss and population displacement.

Extreme climate-related events in Canada, such as the Fort McMurray wildfire in 2016, have caused Canadians to shift their attention to the potential impact of climate change effects on their lives. Catastrophic events are expected to amplify risks to homeowners and taxpayers as mitigation and adaptation efforts are delayed.

There is urgency to increase climate risk awareness in Canada and create the measures and mechanisms to improve how climate-related risk is managed. These are important steps to help industry and consumers adjust to increased exposure to losses due to climate change.

LIMITED AWARENESS ON CLIMATE-RELATED RISKS Despite the urgency brought about by climate change, current and future homebuyers do not fully understand how they can be impacted by climate-related risk. According to a Leger survey commissioned by RE/MAX Canada, only one in four Canadians worry that climate change will impact their home/neighbourhood and their home-buying journey over the

next five years. Yet, 49 per cent of Canadians are worried about the impact that forest fires, flooding and other weather-related events will have on their neighbourhood and community over the next five years.

Underwriters of property insurance have seen a notable increase in the number and size of claims in relation to climate-related events, which have led to massive insured losses. In 2021, Insurance Bureau of Canada (IBC) reported $2.1 billion in insured damage caused by severe weather in Canada. At the global level, insured damages hit $355 billion according to the Munich Reinsurance Company.

This loss trend affects the balance sheet of insurers and is triggering changes to how business decisions are made across the

industry. As the pricing of climate-related risks gets more complex, insurers are evaluating the exposure of their underwriting portfolios to physical climate risk. At the same time, homeowners with properties in flood-risk areas are being affected by significant premium increases.Up to 10 per cent of Canadian homes are uninsurable due to flood risk, according to the IBC. Homebuyers who are not able to secure adequate property insurance may have their mortgage application denied “to satisfy lenders’ requirements” after ‘property insurance’.

Efforts to understand climate-related risk to physical infrastructure have not been a priority in Canada, and this has left consumers and industry alike unprepared to consider and assess risks related to climate change when

Insured Catastrophic Losses in Canada

*A catastrophic loss = 1 event costing $25 million or more in insured damages

$ Billion

5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

Loss + Loss Adjustment Expenses

Estimated Trend

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021*

Source: IBC Facts Book, PCS, CatlQ, Swiss Re, Munich Re & Deloitte Values in 2020 $ CAN, *2021 preliminary

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making decisions about where to live or what investments to make.

With the expectation that the number and severity of climate-related events will increase, it becomes more urgent to integrate climate-related risk assessment into property underwriting criteria, and for current and future homeowners to be informed about the risks they face and how they can mitigate for these risk factors.

According to IBC, the greatest cumulative insured losses in Canada are being caused by flooding, where one in five residential properties are at risk of overland flooding. In B.C., even though overland flood insurance is available to about 95 per cent of properties, just half of B.C. residents have obtained coverage. This points to the need for increased awareness of the risks and costs associated with climate-related events. For example, the most recent catastrophic flooding in the Sumas Prairie in the City of Abbotsford in late 2021 resulted in $675 million in insurable losses. Most payouts were associated with commercial policies as most residential properties did not have flood insurance coverage. Infrastructure and emergency response and recovery costs are estimated to surpass $4 billion, and these are being borne by the government.

STEPS TO IMPROVE CLIMATE RISK ASSESSMENT AND MANAGEMENT IN CANADA The Bank of Canada is taking steps to better understand the impacts of climate change on the economy. It recognizes that both climate change and the transition to a low-carbon economy will impact almost every sector of the economy, and it is within its mandate to better understand these effects and their implications for the economy and financial system.

In its most recent Financial System Review, the Bank reports that the risk of a quick repricing of assets exposed to climate change has increased. “The vulnerability associated with climate change stems from the likelihood that the pricing of assets exposed to either physical or transition climate risks does not fully reflect the hard-to-measure future economic risk factors due to climate change.” For a description of physical and transition risks, see sidebar.

The Bank also reports that for “financial instruments to be appropriately priced, market participants need access to reliable information on firms’ and financial institutions’ exposure

to climate-related risks and on their transition plans. The current level of disclosure is not enough to properly assess these risks.”

The Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI) conducted a climate transition scenario analysis pilot project, which included several Canadian financial institutions to gain an understanding of potential risks in transitioning to a low-carbon economy and to build the capabilities of authorities and financial institutions in assessing climate-related risks. Key takeaways and lessons learned to inform and support the broader financial sector were released earlier this year.

Since then, OSFI has issued a draft version of Guideline B-15: Climate Risk Management, which sets the stage for OSFI’s expectations of federally regulated financial institutions. OSFI will be also introducing mandatory climate-related financial disclosures aligned with the Task Force on Climate-Related Financial Disclosures (TCFD) framework. It is reported that these disclosures will incentivize improvements in the quality of the institutions’ governance and risk management practices related to the climate.

The Bank of Canada is also working with international partners such as the Network for Greening the Financial System, among other partners, to develop strategies to mitigate transition risks and promote sustainable finance. These are much-needed steps to bring awareness to the risks of climate-related events to the financial sector. This will also help and support financial institutions in building their capacity for climate-related risk assessment and management, while increasing transparency.

TRENDS IN CLIMATE RISK ASSESSMENT REPORTS In Canada, most lenders, appraisers and insurers rely on out-of-date flood maps to assess climate-risk to properties, which may affect closings and existing loans for homebuyers or homeowners and business owners.

Historically, lenders and insurance companies in the U.S. have relied on the Federal Emergency Management Agency (FEMA) maps to evaluate flood risk and to inform consumers about the requirement or recommendation for flood insurance. According to a study released earlier this year by the Research Institute for Housing America (RIHA), the housing industry lacks an accepted indicator of

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editorial

climate risk projections that lenders can use for risk management.

In response to the growing need for climate risk information, the private sector is coming up with solutions to allow decision-makers to quantify climate risk in their mid- and longterm strategies. These solutions are often powered by predictive analytics, which can generate quantified assessments about current and future risk from climate-related events.

For example, ClimateCheck® offers climate risk solutions for corporate customers, such as real estate investors, environmental consultants, lenders and insurance companies. Climate- Check® runs on a proprietary risk assessment model to quantify climate-related risks for a property or a portfolio of properties.

The non-profit First Street Foundation® offers a free online tool for homeowners to find their property’s risk from environmental threats such as flooding and wildfires, and to understand how risks are changing because of a changing climate.

These solutions are giving property owners information about the risks they face from climate-related events, particularly flooding and wildfires.

The launching of similar services in Canada that combine climate data sets with predictive analytics can be part of a pathway to alleviate the immediate need for climate-risk

“

Protecting

Canadians, the economy and the financial system will very much depend on the implementation of climaterelated financial disclosures and broader climate risk management frameworks.

awareness and help build capabilities to support decision-making. Regulators may want to screen these services to ensure compliance with any applicable legislation and alignment with applicable risk management guidelines.

The need for climate risk awareness and management in Canada is undeniable. While integrated efforts across government and industry are needed to implement the federal government’s commitment to transition to a

low-carbon economy, helping current and future homeowners and the public at large better understand the potential impact of climate change on their properties is a step in the right direction. Protecting Canadians, the economy and the financial system will very much depend on the implementation of climate-related financial disclosures and broader climate risk management frameworks.

CLIMATE RISK MANAGEMENT: OVERVIEW

Climate change and the global response to the threats it poses have the potential to significantly impact the safety and soundness of federally regulated financial institutions (FRFIs) and the financial system more broadly. These risks, also known as “climate-related risks,” are broadly categorized as physical and transition risks.

• “Physical risks” refer to the financial risks from the increasing severity and frequency of extreme climate changerelated weather events (i.e., acute physical risks); longer-term

gradual shifts of the climate (i.e., chronic physical risks); and indirect effects of climate change such as public health implications (e.g., morbidity and mortality impacts).

• “Transition risks” refer to the financial risks related to the process of adjustment towards a low-greenhouse gas (GHG) economy. These risks can emerge from current or future government policies, legislation and regulation to limit GHG emissions, as well as technological advancements, and changes in market and

customer sentiment towards a low-GHG economy.

Physical and transition risks can also lead to liability risks, such as the risk of climate-related claims under liability policies, as well as direct actions against financial institutions for failing to manage their climate-related risks.

Climate-related risks may manifest over varying time horizons and are likely to intensify over time, especially if the global economy undergoes a disorderly transition. They can drive financial risks, such as credit,

market, insurance and liquidity risks. They can also lead to strategic, operational and reputational risks. In severe instances, climate-related risks can threaten the long-term viability of an FRFI’s business model.

Building resilience against climate-related risks requires FRFIs to address vulnerabilities in their business model, their overall operations and ultimately on their balance sheet. This entails forward-looking approaches that are holistic, integrated and built on reliable empirical data and sound analyses.

Source: Office of the Superintendent of Financial Institutions (2022). Climate Risk Management (Draft Guideline B-15; p. 15). https://www.osfi-bsif.gc.ca/Eng/Docs/b15-dft.pdf

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