Updated 7 February 2022
On Friday 14 January the Bank of Canada and Canada’s Office of the Superintendent of Financial Institutions (OSFI) released a report on a pilot study respecting the potential impact of climate change on Canada’s major financial institutions. Canada’s central bank and OSFI are jointly responsible for the stability of Canada’s financial system. As international organizations mobilize resources to understand the linkages between national and global climate change policy shifts, there is a growing unease among regulators on how prepared banks and insurers are in understanding and managing credit risk and market risk of clients who are especially exposed to climate change policies.
See my article in The Conversation
Purpose of report
The pilot study reported findings from a sample of six large federally regulated financial institutions in order to better understand the risks to the financial system that could arise from a transition to a low carbon economy. Participating institutions included RBC, T-D, Intact Financial, Co-operators Insurance, SunLife Financial and ManuLife Financial. The pilot analyzed four climate scenarios with the objectives of:
- building the capabilities of authorities and financial institutions in climate scenario analysis and help the Canadian financial sector improve its assessment and disclosure of climate-related risks;
- increasing understanding of the financial sector’s potential exposure to a range of risks that may come with a transition to a low-carbon economy; and
- improving authorities’ understanding of financial institutions’ governance and risk management practices around climate-related risks and opportunities.
This exercise continues the work of an international body known as the Network for Greening the Financial System (NGFS),consisting of “at least 31 central banks and regulators around the world” jointly undertaking scenario analysis to better understand the macroeconomic and financial impacts of climate change.
The study’s authors believe that, given the high degree of uncertainty around climate change, notably the national and international rate of adopting climate change policies and the pace of technological progress, scenario analysis gives financial supervisors and institutions a process for “examining and evaluating plausible future pathways under certain conditions and assumptions.” The scenarios used in this pilot project are designed to be “intentionally adverse” That is having the potential for stressing economies and the financial system.
Scenario Analysis
The scenarios are aligned around the Paris Agreement to limit global warming below 2°C and a more ambitious 1.5°C, or net-zero, goal. The focus of the analysis relates mainly to U.S. and Canadian credit and market exposures to companies in 10 industries: crops, forestry, livestock, coal, crude oil, gas, refined oil, electricity, energy-intensive industries and commercial transportation.
OSFI and the central bank worked from the Massachusetts Institute of Technology’s Emissions Prediction and Policy Analysis (EPPA) model. This EPPA model represents the world’s economy across several countries or regions and sectors relevant to the Canadian financial system. Then the authors used two of the central bank’s macroeconomic forecasting models- the Terms-of-Trade Economic Model and its Global Economy Model with Financial Frictions model, a five-region model for the global economy.
Chart 3 (from the analysis) show the projected path for producer received energy commodity prices under the below below 2°C trend in carbon prices. This pathway shows that coal prices will fall more quickly and deeply than either oil or natural gas prices. Oil and natural gas prices are expected to remain fairly stable over 2020-35 then falling gradually to 80 percent of the current price level. Chart 4 illustrates the change in GHG emissions. The baseline or 2019 scenario shows there is no carbon price and consequently GHG emissions remain the same. The net-zero 2050 ( 1.5°C ) scenario shows GHG emissions fall from about 55 Gigatonnes today to about 10 Gigatonnes by 2050.
Charts-OSFI-BoC-report2
Financial Impacts
Below are forecasts for energy commodity prices for coal, oil and natural gas. Natural gas prices hold up better than the two more GHG intensive fuels- coal and oil. These price forecasts are obviously not good for the financial returns to these fossil fuel industries in the long-term to 2050, with natural gas the most price resilient being the less GHG intensive.
The report next maps the scenario variables to financial impacts on the financial institutions who have either a credit exposure (bank lending or bond issuance) and the market exposure (equity prices of energy companies). The six pilot participants have a total credit exposure of $240-billion to the various sectors (Chart 1) with an oil and gas exposure of ap0proximately $72-billion and a market exposure to these sectors of $22-billion with roughly $7-billion to the oil and gas sector (Chart 2).
Chart 10 shows the impact of below 2°C scenarios on the oil and gas and electricity industries. This chart illustrates a step reduction in revenues, net incomes and other costs in the oil and gas sector. A key question in the federal government’s policy development is whether CCUS will be funded by taxpayers or shareholders. Electricity fares considerably better with gains in new income and revenue.
The final chart 18 shows the change in the probability of default in Canada by 2050 under below 2°C scenario. In the case of the probability of default for oilsands producers, this is predicted to rise by nearly 450 per cent. In the case of certain renewables the probability of default falls. In other energy intensive sectors like air transportation, chemicals and primary metal manufacturing probability of default rises by 20 to 45 per cent.
Listen to my interview with Shaye Ganam on 7 February.
What does this mean for Alberta’s government and the oilpatch?
Whether federal politicians understand the powerful tools it possesses with respect to the fate of oil and gas production, and especially oilsands production, is not fully known. Exclusive federal jurisdiction over banking and its extensive jurisdiction to incorporate and regulate federally-incorporated insurance companies mean federal regulators possess the capacity to influence how much credit flows to Canada’s oilpatch. This reality of significant dependence on banking capital and investment capital has not been lost to environmentalist. The divestment movement has achieved significant notoriety with many financial institutions and institutional investors joining consortia to make pledges to divest oil and gas holdings. The divestment movement has achieved key victories on Canadian and U.S. campuses and the Caisse de Depot has stated in will unload its energy holdings by the end of this year. Harvard University has also agreed to divest from its $42-billion U.S. holdings all fossil fuels. And the list goes on.
The growing requirements being placed on all corporations to disclose their emissions profile as part of ESG reporting (environmental, social and governance) will also be a continuing topic of debate at meetings of the Canadian Securities Administrators (CSA). The CSA is a provincial group of securities regulators responsible for regulating the issuance of securities (debt and equity) in Canada’s capital markets. Tas an intergovernmental body the CSA is responsible to formulating national policies to facilitate the smooth functioning of securities markets across Canada. For nearly one hundred years the federal government has been trying to find a way to move into securities regulation without success. Most recent efforts begun under the Chretien Liberals and carried forward by the Harper government has tired to use financial system stability as a means of creating a common market for securities. Canada is the only majorG-7 country without a national regulator. Alberta which has steadfastly defended its jurisdiction it expected to slow progress of standardizing disclosure for the oil and gas corporations it regulates. This will likely be a rearguard action as most national governments now understand the centrality of capital for the industry.
Particularly troubling will be the evidence found in Chart 18- the probability of default rising significantly particularly for oil sands producers. In addition to this problem is the burning question about how will future Alberta governments and their regulators address the vast environmental liabilities in the tailings ponds. This is a question that keeps getting asked by Alberta’s Auditor General and will become one of the central questions for oilsands producers from their banking consortia. With the Supreme Court’s decision in Redwater in January 2019, banks can no longer wiggle out of environmental liabilities in a bankruptcy. A major rupture at one of the tailings ponds would expose some of Canada’s largest financial institutions to enormous liability. We can therefore expect that whether or not the oilpatch is successful in getting the federal taxpayers to subsidize carbon capture and storage, federal financial institutions and their prudential regulators will be carrying out more intensive credit and supervisory reviews respecting both oil and gas and oilsands borrowers in the coming months.
This federal regulatory process may also have implications for ATB Financial, the provincially owned financial institution. At the end of September 2021, ATB had loans outstanding to the oil and gas industry of $3.8-billion. Will ATB become increasingly politicized as loan capital to the oilsands and oil; and gas sector become increasingly tight?
In a future post, I analyze the use of major oil and gas companies extra cash flow with oil and natural gas prices at their highest levels since 2014.
Related Posts
https://abpolecon.ca/2021/05/30/international-energy-agency-bombshell-report/
https://abpolecon.ca/2017/10/31/transitioning-to-the-clean-energy-economy/